A put option is a contract that gives the buyer the right, but not the obligation, to sell an

underlying security to the writer of the option at an agreed-upon strike price within a certain
period or on a specific date. American options may be exercised anytime before the expiration
date, while European options may only be exercised on the expiration date. If the contract writer
does not have an offsetting short position in the underlying stock that the contract is written on,
the contract (in this case, "put") writer holds an uncovered position. If the writer has sufficient
cash in his account to buy the underlying stock at the strike price, the position is considered a
cash-covered put. Writing a naked put with insufficient cash-to-cover is considered risky because
the writer could be subject to a margin call upon receipt of an exercise notice.

Payoffs and profits from writing a short put

A naked put (also called an uncovered put) is a put option where the option writer (i.e., the
seller) does not have a position in the underlying stock or other instrument. This strategy is best
used by investors who want to accumulate a position in the underlying stock - but only if the
price is low enough. If the investor fails to buy the shares, then he keeps the option premium as a
'gift' for playing the game.

If the market price of the underlying stock is below the strike price of the option when expiration
arrives, the option owner can exercise the put option and force the writer to buy the underlying
stock at the strike price. That allows the exerciser to profit from the difference between the
market price of the stock and the option's strike price. But if the market price is at or above the
strike price when expiration day arrives, the option expires worthless and the put writer profits
by keeping the premium collected when the put option was sold. A naked put is like buying a
stock at a discount on lay away. You can buy "reserve" the stock at a cheaper price and deposit
money over time to cover the cost of delivery of shares to your account in the future as you get
closer to expiration, converting over time the naked put to a cash secured put.

The potential loss on a naked put can be substantial. If the stock falls all the way to zero, the loss
is equal to the strike price minus the premium received. The potential upside is the premium
received when selling the option. If the stock price is at or above the strike price at expiration,
then the option seller keeps the premium and the option expires worthless. During the option's
lifetime, if the stock moves lower, then the option premium may increase (depending on how far
the stock falls and how much time passes), and it becomes more costly to close (repurchase the
put sold earlier) the position - resulting in a loss. If the stock price completely collapses before
the put position is closed, then the put writer can face potentially catastrophic losses.