Selling Naked Puts - We Bare All

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The India
Street wants to keep our readers informed of creative financial tools for
making money. We therefore created a video explanation of
a naked put (for those that like simplicity) and below we have put together
a technical example (for you hardcore stock enthusiasts) of a naked
put for Reliance.

Reliance Naked Put Option Example

A Reliance Put Option at a strike price of Rs.1800 with expiry date 31-May-07
means a contract which gives the holder the right, but not the obligation to
sell 150 equity shares at a Rs.1800 on or before 31-May-07. The person who
sold the option is known as the option writer. A naked put option refers to a
put option in which the option writer does not have a short position in the
contract or underlying stock i.e. has not sold the contract without owning it.

In other words, if he has shortsold the contract he can square it off by
buying back on or before expiry; Since he has not short sold the option
contract he will get the premium paid to him in case the buyer chooses not to
exercise the option. However, if the market price of Reliance remains below
Rs.1800 on the expiry date the option holder may wish to exercise the option
by purchasing Reliance shares from the market for, say, Rs.1750 and selling it
to the option writer. The buyer gets a profit of Rs.50 per share.

On the last Thursday of April 2007 i.e. 26-Apr-07 the options contracts for
the month of April expired and fresh series for the month of May were
introduced. The market price of Reliance on 27-Apr-07 was Rs.1539. The
Reliance Put Option premium for the 3 strike prices (above market price)
traded are given below.

The premium paid is on close basis. The put option contract cannot be
exercised without profits unless the market price falls below (strike price –
premium) or 1509.85, 1521.45, 1531.45 respectively for the above contracts.
Brokerage, commissions and other taxes are not included in this calculation
and have to be considered separately for both options transactions and equity
share purchases from the market.

During the month of May the market price of Reliance kept going up. The
contract strike prices are fixed by the exchange in increments of Rs.30 for
Reliance. 1650 strike price contracts began to trade from 03-May-07. As the
market price of Reliance was increasing the premium amount of put option kept
decreasing, since there was no way of exercising the option.

1800 strike price contracts began to trade from 22-May-07. The premiums for
1800 strike price contracts are given below.

Let us assume that on 22-May-07 someone bought a put option by paying Rs.44 as premium. On 28-May-07 the market price of Reliance was 1724. So, he could buy from the market at this price and sell to the option writer at Rs.1800. His
profits would work out to 1800 - 44 - 1724 = 32 per share or Rs.4800 for 1 lot
of 150 shares. (Derivatives like futures and options are always traded in
lots.)

The potential risk to the option writer in this case would be, strike price –
premium or 1800 – 44 = 1756 for 1 share of Reliance or Rs.263,400 for 1
contract. If he is lucky enough he can sell the Reliance shares at a later
date in the market for more than Rs.1800; otherwise he may have to sell for a
lower rate and accept the loss.

On the contrary, a ‘covered put’ on Reliance would mean being short on the
Reliance stock while selling a put option. The put option, when exercised,
will force the option writer to buy Reliance from the option holder. Since the
option writer is already short on the market, he can buy the stock from the
option holder to square off his short positions, thus reducing his risk.