Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Losses On Naked Puts? Uncovered Put Options?

If your broker suggested that you sell put options (also called an 'uncovered puts') and you lost money, you may have a claim that the strategy was not suitable for you, depending upon your level of financial sophistication.

The seller of an uncovered put (you for example) collects a premium from the buyer and is contractually bound to purchase the underlying stock at a specified price for a given period of time, generally 90 days or so. If the price of the stock goes up or remains unchanged, then the option will not be exercised (ie: the person who paid you the premium will not force you to buy the stock) and you will have benefited to the extent of the premium you collected.

This all works very well in a bull market, but what about a bear market, or if the particular stock on which you sold the put option falls dramatically? Your losses can be enormous, a fact often misunderstood by unsophisticated investors or overlooked in the explanation from broker.

Here is an example from a recent case involving the sale of put options on S&P 500 Index.

In early August of 2008, at a time when the financial markets did not look particularly stable, Mr. Smith (name used for this example) sold 10 put options on the Nov 1075 S&P index. On the day of the sale the S&P 500 index was about 1300. Mr. Smith collected $7 per share for a total of $7,000 (each option is for 10 shares). For the $7,000 paid by the buyer, Mr. Smith was obligated to buy 1,000 shares at a price of $1075 at any time up to the expiration date of the options (third friday in November 2008).

Since, at the time of the sale, the index was 125 points above the exercise price of 1075, one might think this was a nice way to make an easy profit. That is not the case. The index dropped and rebounded over the rest of August and early September and in late September fell below 1075. Ultimately the position was closed out when the index was 899, at a price of $166 per share.

Net result was a loss of $159,000 on this transaction that lasted just 60 days. The total upside of this transaction was the $7,000 premium collected on the sale of the option.

We have consulted with a number of clients who were encouraged by their brokers to write uncovered puts who were never made aware of the huge potential downside risk associated with such a strategy. If you experienced losses on an option strategy suggested by your broker that you did not fully understand, you may have legal rights that could result in the recovery of losses.

We have been helping investors recover stock market losses due to the negligence and fraud of stockbrokers, investment advisers and stock brokerage firms for over twenty years. Call us at 561 391 1900 or visit our website.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.