Put plain and simply, Puts are a contract between the buyer and seller whereby the seller agrees to sell shares of a given stock if the price drops to a certain level. For example: Let’s say GE’s stock is selling for a price of $27.00 but you believe the price is a bit too high and you would prefer to purchase the stock at a price of $25.00 per share. Let’s also say that over the next three to six months you believe the price will drop to $25.00 or less. One option you have is to sell a $25.00 Put option (that’s why they’re called options) which will expire in the next three to six months. Note: The word “naked” simply means that there are no actual equity (i.e. stock) shares accompanying the Put option.
OK, what the heck is he talking about? Well, let me break it down this way. Let’s pretend that today is September 1st of the most current year and that GE is currently selling for $27.00 per share. If you sell a December (same year) $25.00 Put option you are essentially agreeing to purchase (from the buyer of the Put) 100 shares of GE’s stock at a price of $25.00 per share (i.e. if the price drops to $25.00 or less before, or by, the end of December). Why would I want to do that you ask? The reason is pretty straightforward: It’s because I wouldn’t mind owning GE’s stock at $25.00.
Here’s where it can get a bit confusing, and where the real danger lies, however. The Put option is essentially a contract between the seller and the buyer, where the seller agrees to purchase the shares at $25.00 even if the price drops to, say, $10.00 per share. The reason the buyer is willing to make the deal with you is because he or she is trying to protect his or her investment. For example: The buyer may have purchased the GE shares at $26.50 and wants to buy the $25.00 Put (i.e. make the contract with the seller) so that they will protect their investment if the price of the shares begins to move against them (i.e. if the stock price starts to go down). If the buyer purchased the shares on the basis that GE is a good company, with a very competitive dividend, but is afraid they may be wrong, then they can buy the $25.00 Put to protect their investment if the stock begins to move against them (i.e. down in price). In this regard, the Put seller is insuring the buyer’s investment against losses (much like an insurance company insures your house when you purchase home insurance). The Put acts like an insurance contract for the buyer, and the seller is, essentially, the insurer.
One reason for the seller’s motivation to sell the Put may be that he or she believes they will be buying a very well-known, large company with a decent and reliable dividend at a discount price. Unfortunately, however, there is the risk that the stock moves against the seller, too. If the price were to drop to $10.00 per share, then the seller would be purchasing the shares at a $15.00 per share loss, which would hurt – a lot! That is essentially the biggest risk behind this strategy; but, as with almost anything in life, for there to be any gain there are always certain risks involved.
Personally, I will only use this strategy with large, well-established companies that offer relatively decent and stable dividends. I like the strategy because it enables me to make some money while waiting for the price of the stock to come down. The money comes from what is called the “premium.” The premium is the money the buyer pays for me to insure his or her investment. For example: Let’s say that the December $25.00 Put for GE sells at a premium of $1.00, I would receive $100.00 for each Put I sold ($1.00 x 100 shares) and that $100.00 is mine to keep whether or not the shares of GE drop to $25.00 (or less) or not. Therefore, if the price, by the time of expiration (the end of December), drops to $25.50, I keep the $100.00 and I am not required to purchase the shares from the buyer of the Put. If, however, the price drops to $24.50 then I am responsible for purchasing 100 shares (remember 1 Put contract = 100 shares) at $25.00, but I also get to keep the $100.00 premium. Thus, my total costs for the GE shares would be $2400.00 ($2500.00 – $100.00 = $2400.00), less any commissions.
So, in the end I own 100 shares of GE for $2400.00 (again less any commissions) – much less than I would have paid if I purchased the shares at $2700.00, or the original $27.00 per share price three months earlier. And, though there may be risks, I have been fortunate over the years to find some extraordinary deals with this strategy
