A naked put is when a put option contract writer or short-seller does not have the resources (shares of the security) on hand to cover the position if the option is exercised.
Put options are contracts between two people who have been put together with the help of an options exchange or clearinghouse.One of them will be the “writer” who sells the put on a certain underlying stock with a certain strike price and expiration date.
The buyer who owns the contract will have the ability to force the writer (or another writer that he is randomly assigned to) to buy 100 shares of the underlying security from him at the strike price, regardless of what the market price for it currently is.
Put writers can get into trouble if they are merely out looking to collect premiums for options contracts that they hope will never be exercised or assigned to him. If a writer doesn’t have enough liquidity, or another strategy in place to give him the liquidity, this can be called a Naked Put. The amount of loss is limited, however, to the strike price of the option reduced by the premium collected by the writer.
If the writer sees that the price of the underlying is dropping, he can try to buy the put “back” (which can be accomplished by getting it from anyone, not just the person he sold it to), but the premiums for it will be going higher and higher and it may not be affordable or advantageous at that point.
A covered put is when the writer has also short-sold the actual underlying stock and therefore has liquidity in the proceeds of that sale to cover the short put since the stock would have sold short at a higher price than the strike price of the option.
Another example of a naked option is a Naked Call, but in that case, there is an unlimited amount of loss possible if the position is uncovered.
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