A stock option is a contract that gives investors the right (but not the obligation) to buy, or sell, 100 shares of stock at a strike price by the expiration date of the option. The strike price is a theoretical price that may or may not be reached by the expiration date. Depending on your investment strategy, the market price may be above or below the strike price, and a profit may be realized in either case. Holders of ‘call options” make a profit when the market price ends up above the strike price, because they were able to lock-in a purchase price for a stock that was lower than the actual market value at the time of expiration. Put options, on the other hand, are profitable when the holder exercises the option at a time when the current market value is below the strike price.
There are a number of strategies with respect to options; however, the best strategy for an investor is often determined by his or her appraisal of the market. Different market conditions (such as a “bull” or “bear”) will make some option investment strategies more prudent than others. If an investor fails to understand which direction prices are trending towards, then it is very probable that he or she will choose a strategy that is at complete odds with the market. If prices are not expected to head south – that is they will not drop and may even rise before the expiration date, then the investor may wish to use the “sell naked put” stock option investment strategy.
The danger of the “sell naked put” option strategy is that it carries a lot risk (the extreme case would be if the stock price goes down to $0 at or before expiration). In other words, if the price of the stock falls below the strike price, the writer of the options is liable for the loss. Investors using the “sell naked put” stock option investment strategy are obligated to sell 100 shares of a given stock at the strike price, if the holder of the option decides to exercise it before or at the expiration date. A writer using the “sell naked put” strategy has his/her profits limited to the premium amount (minus commissions). Thus, the break even point for the “sell naked put” stock option strategy is the strike price, minus premium, less commissions.
Followers of the “sell naked put” strategy should sell options with lower strike prices when they are not entirely certain about the direction of prices, but are still confident that prices will not drop. If the investor is more certain that prices will not drop before the expiration date, then it is safer to sell options with higher strike prices (and therefore the premiums, and potential profits, will be higher). However, as the “sell naked put” option strategy has quite a lot of risk, it is not recommended for novice investors. This is especially true since margin is typically a requirement for those utilizing this option investment strategy.