Covered Calls and Naked Puts Introduction

There is an option strategy known as “naked puts”, or “uncovered puts”, that involve the sale of a put rather than the sale of a call. This strategy is similar to covered call writing in several ways and is therefore often considered an alternative to covered call writing. However, when comparing these two strategies, investors will find that covered call writing actually can produce higher returns with less risk.

Before discussing the similarities and differences of naked puts and covered calls, investors need to understand that writing naked calls requires special permission from their broker. Writing naked puts requires what many brokers call “Level 3” option clearance, which is the highest level of option approval. “Level 3” is consider the riskiest of all option strategies by a broker. Writing covered calls requires “Level 0” approval, which is the lowest level. Furthermore, writing covered calls is considered the lowest risk option strategy, and is the only one that can be used in an IRA account.

In order to understand this technique, it is also important that investors have a basic understanding of puts. A put gives the holder of the option contract the right to SELL the stock to the writer for a specified price on the strike date. What this means is that you can sell someone the right to sell their stock TO you at a certain price. This is in contrast to selling a call, which sells someone the right to BUY your stock at a given price.

When selling a naked put, investors sell a put rather than selling a call. Being in a “naked” position means that you do not own the underlying stock. Before selling the put, you will need to select a strike price. You will receive the option premium when you sell the put, which is deposited almost immediately into your account. If on the strike date the stock price closes above the strike price, then nothing else is required from you, and you have made a profit. However, if the stock closes below the strike price then you will be required to purchase the number of shares that you initially agreed to, and you will now own those shares in your portfolio.

When you sell a naked put, you are not completely “naked.” Your broker will require that a certain amount of equity in your account. This means that the net value of your account must be greater than a predetermined amount. Furthermore, you will be required to keep a certain amount of cash in your account. Many brokers have formulas that they use to calculate the cash requirement for naked puts and calls. The amount of cash required in your account will vary from broker-to-broker. For more information on the cash requirement, it is best to contact your individual broker.

In many ways this is like a covered call in reverse, in that you only buy the stock on the strike date, rather than sell the stock on the strike date.

1. Covered Calls and Naked Puts Introduction
2. Similarities Between Covered Calls and Naked Puts
3. Differences Between Covered Calls and Naked Puts
4. Summary of Covered Calls and Naked Puts
5. Writing a Covered Call While Also Buying a Put