The amazing thing about the stock market is that there are multiple ways to turn a profit. Examples range from the traditional “buy low, sell high” investment strategy to short selling and even trading derivative contracts such as options.
Two popular options strategies among advanced traders are put spreads and naked puts. Before we dive into what put spreads and naked puts are, learn more about options trading and then decide whether one of these is right for your investment strategy.
How Options Trading Works
An options contract gives its owner the right—but not the obligation—to buy or sell a fixed security at a predetermined price in a given time frame. It also provides investors additional opportunities to manage their portfolio risk. Each options contract generally allows the owner to buy or sell up to 100 shares of the corresponding asset.
“Options differ from long-term buy-and-hold because they carry an expiry date, and it's this additional dimension that vastly alters the evaluation process,” Emmet Savage, CEO of investment app MyWallSt told The Balance via email. "Deciding if a company's prospects are good or bad is one skill. Making a call on whether the market will agree with you before a certain date is an entirely separate competency."
There are two types of options—calls and puts—both of which investors can either buy or sell in the open market.
Options contracts attract a premium, a price that the buyer of the contract pays to compensate the risk to the seller of the contract.
Buying Call Options
Investors benefit from buying a call option if they expect the underlying asset will increase in value.
For example, let’s say ABC stock is currently trading at $100 per share and you believe it will likely trade at $115 per share in the near future. Because of this, you decide to purchase a call option with a premium of $5 a share.
How would you profit from this call option? If ABC stock rises to $115 per share, you can purchase 100 shares of that stock for $100 per share (as per the options contract) and you pay $500 in premium ($5 x 100). You’d get 100 shares for $10,500 even though they’re worth $11,500. This makes you an immediate profit of $10 per share ($15 growth per share - $5 premium = $10).
Buying Put Options
Investors benefit from buying a put option if they expect the underlying stock is going to decrease in value.
For example, let’s say XYZ stock is currently trading at $100 per share, and you expect it to trade at $85 per share in the near future. You decide to purchase a put option at a premium of $5 per share.
How do you profit from this put option? If XYZ stock decreases to $85 per share, you can purchase 100 shares of XYZ stock at its current price of $85, with your cost being $9,000 after paying the $5 per share premium. You can then sell those shares at $100 per share (as stated in the options contract) making a profit of $10 per share.
Writing Call and Put Options
Another way investors benefit from options contracts is by selling options contracts. The seller of an options contract makes money from the premium received when selling the contract.
Selling an options contract is also called writing an options contract.
For example, if you were to buy an options contract for 100 shares and the premium was $2.20 per share, you’d pay $220 for the contract. The seller would pocket that $220.
What Is a Naked Put?
A naked put is a put contract sold that has no offsetting positions. You may sell a put option contract without actually owning short positions of the underlying stock at the time of the sell. Sellers of naked puts benefit from the options contract when the underlying stock price goes up.
The maximum benefit on naked puts is the amount of premium collected by the seller on the option contract sold. The risk, however, can be substantial given that theoretically, the stock price can fall all the way to zero. If that happens, the seller of the naked put would have to buy a worthless stock at the strike price.
In contrast, a covered put means you have a short position in the underlying stock when you sell the put contract. For example, you might sell a put contract on EFG while also being short at least 100 shares of EFG to hedge your position
What Is a Put Spread?
A put spread is an options trading strategy where investors buy and sell the same amount of put options at the same time to hedge their positions.
For example, someone might implement a put spread strategy by selling a put option of ABC stock while also buying a put option of ABC stock at the same time. Should their purchase of the put option go south, they have limited their loss by simultaneously selling a put option on the same stock.
Bullish and Bearish Put Spreads
There are bullish and bearish strategies for put spreads, both of which consist of buying and selling put options on the same underlying stock at the same time to limit your risk.
Bullish put spreads consist of selling a put option with a higher strike price while at the same time buying a put contract at a slightly lower strike price. You could make money from the premium received if the underlying stock price increases. If the underlying stock price decreases, you’d have limited your loss by purchasing a put contract to offset the put option you sold.
Bearish put spreads consist of buying a put contract with a higher strike price while simultaneously selling a put option at a slightly lower strike price. You could make money if the underlying stock price decreases. If the underlying stock increases, you’d have limited your loss by selling a put option to offset the put contract you purchased.
In both bullish and bearish put spreads, you’re limiting your potential losses by offsetting your positions with a put contract that makes money should your primary strategy not go as planned.
Naked Puts vs. Put Spreads: Which Should You Choose?
Whether you choose naked puts or put spreads is entirely dependent on your overall risk tolerance with your investment portfolio. Naked puts come with more risk but also have the potential for higher returns. Put spreads come with slightly less risk at the cost of slightly lower potential returns.
These strategies are not for every investor, and they may be better left to those with more trading experience. If you’re interested in naked puts or put spreads, first analyze your portfolio risk. Align that with your portfolio’s current objectives and then choose the options trading strategy that fits both.
The Bottom Line
Purchasing an options contract is not the same as directly buying stock in a company. It’s a contract to buy a stock at a predetermined price within a stated time frame. Naked puts and put spreads are just two kinds of options trading strategies that can help investors hedge their positions.
Trading options has its benefits, but don’t forget that those benefits come with risks. Beginner investors may be wise to work with an advisor before adding options to their portfolios. In the end, the options strategy you choose to implement depends on your risk tolerance and overall portfolio objectives.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.