The obvious upside of naked puts is that you get to say “naked” without being inappropriate. However, they have downsides as well. A colleague of mine (let’s call him Jim) took the time to understand how naked puts work and reacted the way many people react: they seem like free money. I’ll explain what naked puts are and why they don’t give free money.
Let’s use Jim’s example Bank of Nova Scotia stock (BNS). The buyer of a put option on BNS has the right, but not the obligation, to sell BNS shares at a set “strike” price to the seller of the put option. In Jim’s example, he could sell put options on BNS for $6.25 each. If the BNS shares drop, the option buyer could force Jim to buy BNS shares at the strike price of $66 any time until January. The “naked” part of a naked put refers to the fact that Jim does not have a short position in BNS shares that would be closed out if he is forced to buy the BNS shares.
The way Jim sees it, he can’t lose. If he is forced to buy the BNS shares, he gets them for $66 less the option premium of $6.25, or about $59.75, which is much less than BNS shares trade for as I write this. If he isn’t forced to buy the shares, he gets to keep the $6.25 option premium. He wins either way!
To understand the flaw in Jim’s reasoning, let’s compare his strategy to simply buying BNS shares at the current price. For one thing, BNS shares will pay dividends between now and January. So, the gap between the current price and his apparent price of $59.75 is smaller than it appears because of these dividends.
Next, consider what happens if BNS falters before January. If BNS shares drop in price, the option buyer will force Jim to buy the shares. Jim won’t be as interested in owning BNS shares at an effective price of $59.75 if there is a business reason why their price has dropped.
Now let’s see what happens if BNS shares rise sharply on some good news. In this case, instead of making money from owning BNS shares, all Jim will get is the $6.25 premium. Jim will have missed out on some significant upside.
Writing naked puts isn’t a free ride; it will sometimes work out well and sometimes not so well. Averaged out over time, there is more upside to simply owning stock than there is to writing naked puts.