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Uncovered puts are situations in which the put on an option does not have a short stock position to accompany the put. Sometimes referred to as a naked put, the put option position may also include situations where there is not an equal amount of deposited cash to cover the put. Either of these two scenarios result in a higher degree of risk for the investor, including a higher degree of liability in event the put does not perform as anticipated.
While naked puts with a short put option are a relatively common approach used by a number of investors, there are a couple of points that should be kept in mind. First, the uncovered put does not have the potential for rewards that are associated with other strategies. In fact, the uncovered put often has a very limited reward potential, and this is usually associated with the collection of premiums.
Second, an uncovered put has a built in degree of risk that could far outweigh any potential rewards. This is especially true of the stock associated with the uncovered put goes through a downward spiral in value. This can result in the assignment of the put, which will leave the investor with a substantial amount of debt to cover.
However, even if there is a modest decline in the stock price and the uncovered put is exercised, that does not automatically mean that the investor will suffer a net loss. In the event that the stock price happens to fall below the strike price, there is a good chance that the put will be assigned. This will obligate the investor to pay for the shares at the higher strike price. While this looks like a loss on the front end, there is a good chance that the amount of the premium on the uncovered put will offset the difference and still leave a small amount of net profit for the investor.