Naked Put

Let's take the case of selling naked puts. When a put option is assigned, the seller (i.e., option writer) is obligated to buy shares at a fixed price, regardless of where the underlying market is. For example, the stock might be trading at $20, but if the strike price of the option is $45, the option seller must buy the stock from the put holder for $45 per share.

Given this scenario, it's easy to see why an individual investor would probably view selling naked puts as having limited reward and substantial risk. After all, the maximum profit that can be achieved is limited to the premium received from the sale of the options. A fund manager, on the other hand, might view the situation differently.

By selling slightly out of the money puts, one is able to buy the stock at a discount relative to where it currently trades if the stock moves down in price. At the same time, the position would have earned additional income from the premium associated with the options. If the stock advances, naked put writers haven't missed out entirely because they keep the premium collected from the options that expire worthless.

Example

To truly appreciate this strategy, let's look at the following hypothetical example. Imagine that you want to buy International Business Machines (IBM) but think it is due for a slight correction from its current price, $82.83. By selling the $80 puts at $5.10, you collect $510 ($5.10 x 100 shares) per contract. If the stock drops to $75 and the puts are assigned to you, you will pay $80 for the stock. However, your net cost is really $74.90 per share ($80 strike - $5.10 premium) � a relative bargain compared to buying the stock outright at $82.85!