The Complete Book of Option Spreads and Combinations – Strategies for Income Generation, Directional Moves, and Risk Reduction : [PDF Download]

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“The seller of a put option agrees, in exchange for the premium received, to buy the underlying stock at the exercise price if the owner of the put chooses to exercise his option. Selling a naked put, that is, a put that isn’t covered by either another put option, a short position in the underlying stock or enough segregated cash to buy the stock at the strike price, is a little like getting paid to serve as a target.

Usually, the marke will miss the target, sometimes the minimal damage done is more than made up for by the premium received. Sometimes the impact will really hurt. The maximum potential loss from a naked put is substantial and is many times the investment, in the form of margin posted to cover the potential loss.

However, if the put option seller were to segregate the cash necessary to satisfy his duty to buy the underlying stock at the exercise price, then he’d be certain to be able to satisfy that duty as opposed to the naked put seller, who may or may not be able to fully satisfy the duty to the owner of the option.

A covered put is a combination of a short put and cash. The amount of cash is the sum necessary to buy the underlying stock at the strike price. Because the put is covered by cash it is sometimes called a cash‐secured put.

Covering the put by segregating the cash necessary to buy the stock, if required, doesn’t reduce the risk of the trade, the stock can still drop to zero, it just makes certain the put seller can satisfy his duty.”

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