What it is:
How it works (Example):
The seller, or writer, of a naked put option incorporates a specific quantity of a given security as an underlying in which he does not hold an actual short position. In other words, the seller does not have borrowed shares which may be sold to the purchasing party in the event the market price falls below the strike price. To that end, a seller writes a naked put with the belief in mind that the market price of the underlying security will exceed the strike price. This would allow the seller to profit from the premium received from the sale.
To illustrate, suppose a seller writes a naked put option on 100 shares of stock XYZ with a strike price of $50 and an expiration date of 31 December 2009 which he sells to a buyer for a $500 premium. Provided that the market price of stock XYZ remains higher than $50 through expiration date, the seller will be able to maintain the $500 premium from the sale as a profit.
Why it Matters:
A naked put option provides a profitable opportunity for investors with strong convictions about the behavior of a security price during a specific period. Naked put options are extremely risky because any price movement below the strike price obligates the seller to purchase the specified units of the underlying from the holder without any funds from a short position.