Naked Puts vs. Put Spreads: Pros And Cons

There are numerous ways to make money on the stock market, which is wonderful. Examples include short selling, trading derivative contracts like options, and even the conventional “buy low, sell high” investment strategy.

Put spreads and naked puts are two common options strategies used by seasoned traders. Learn more about options trading before delving into what put spreads and naked puts are, and then choose which one is best for your investment approach.

The Workings of Options Trading

The owner of an option contract has the opportunity, but not the duty, to purchase or dispose of a fixed security at a predetermined price within a specific time frame. Additionally, it gives investors more opportunities to control the risk in their portfolios. Typically, each option contract entitles the holder to purchase or sell up to 100 shares of the underlying asset. 

Emmet Savage, CEO of investment software MyWallSt, wrote to The Balance via email, “Options differ from long-term buy-and-hold since they have an expiry date, and it’s this added dimension that drastically impacts the evaluation process.” One skill is knowing if a company’s prospects are excellent or terrible. Making a prediction on whether the market will agree with you before a certain date necessitates a completely different set of skills.”

Investors can purchase or sell either of the two types of options—calls or puts—on the open market.

Options contracts are subject to a premium, which the contract’s buyer must pay to cover the risk to the seller.

Purchase of a call option

If investors believe the value of the underlying asset will rise, they are better off purchasing a call option.

For example, suppose ABC stock is currently priced at $100 per share and you predict that it will soon trade at $115 per share. As a result, you decide to spend $5 per share in premium to buy a call option.

How could this call option benefit you? If the price of ABC stock increases to $115 per share, you can buy 100 shares for $100 each (as stated in the options contract), and you’ll pay $500 in premium ($5 multiplied by 100). Even though 100 shares are worth $11,500, you could purchase them for only $10,000. As a result, you instantly get a $10 profit per share ($15 growth per share minus $5 premium = $10).

A purchase put option

If a stock’s fundamental value is expected to decline, investors gain from purchasing a put option.

Say, for example, that you anticipate XYZ stock, which is currently trading at $100 per share, to drop to $85 per share in the near future. You choose to spend $5 more per share on a put option.

How can you make money with this option? If the price of XYZ stock drops to $85 per share, you can buy 100 shares at the current $85.95 price, making your final cost $9,000 after paying the $5 per share premium. Then, you can sell those shares for $100 per share (as specified in the options contract), earning $10 per share in profit.

Option to Call and PutWriting

Selling options contracts is another way that investors profit from them. The premium collected when selling the contract is how the seller of an option contract is compensated.

Writing an option contract is another name for selling one.

For instance, if you were to purchase an options contract for 100 shares at a premium of $2.20 per share, the contract would cost you $220. That $220.1 would be kept by the vendor.

Describe a naked person.

A sold put contract with no offset holdings is referred to as a “naked put.” It is possible to sell a put option contract without actually holding short positions in the underlying stock at the time of sale. When the price of the underlying stock increases, sellers of naked puts profit from the underlying options contract.

The amount of premium that the seller of the sold option contract received as the maximum benefit on naked puts However, considering that the stock price may hypothetically drop to zero, there is a potential for significant risk. In that case, the seller of the naked put would have to pay the strike price and purchase a stock that was worthless. 

A covered put, on the other hand, indicates that when you sell the option contract, you have a short position in the underlying stock. To hedge your position, for instance, you might sell a put contract on EFG while also holding a short position of at least 100 shares of EFG.

How Do Packed Spreads Work?

In order to hedge their holdings, investors who use the put spread technique buy and sell the same number of put options at the same time.

 For instance, a put spread technique could be used by selling a put option on ABC stock and simultaneously buying a put option on ABC stock. By concurrently selling a put option on the same stock, should their purchase of the put option turn out poorly, they have minimized their loss.

Spreads for bullish and bearish puts

Both bullish and bearish put spread strategies involve simultaneously purchasing and selling put options on the same underlying stock in order to reduce risk.

In a bullish put spread, a put option with a higher strike price is sold, while a put contract with a slightly lower strike price is simultaneously purchased. If the price of the underlying stock rises, you might be able to profit from the premium you received. By buying a put contract to equalize the put option you sold, you would have minimized your loss in the event that the price of the underlying stock fell.

To create a bearish put spread, buy a put contract with a higher strike price and sell a put option with a lower strike price. If the price of the underlying stock falls, you might profit. By selling a put option to counter the put contract you bought, you would have minimized your loss in the event that the underlying stock rose.

You can reduce your potential losses in both bullish and bearish put spreads by balancing your holdings with a put contract that is profitable if your primary strategy doesn’t work out as expected.

Which of the Naked Puts vs. Put Spreads Should You Pick?

The overall level of risk you are willing to take with your investing portfolio will determine whether you choose naked puts or put spreads. Naked puts have a bigger potential return but also a higher risk. Put spreads have a little reduction in risk but a slight reduction in potential returns.

These investment techniques may be better left to people with more trading expertise and are not appropriate for all investors. If you’re considering naked puts or put spreads, first assess the risk in your portfolio. Choose an options trading strategy that satisfies both of those criteria after comparing it to the existing goals of your portfolio.

The conclusion

Buying an options contract is not the same as buying business stock directly. It is an agreement to purchase stock within a specified time frame at a predetermined price. The two types of options trading methods that might assist investors in hedging their positions are naked puts and put spreads.

While there are advantages to trading options, don’t forget that there are also hazards involved. Nonnegotiable investors might want to consult with a financial professional before including options in their portfolios. The option strategy you decide to use ultimately depends on your risk appetite and overall portfolio goals.

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