A short put, also known as a sell put, is a trading strategy where an investor sells a put option with the expectation that the underlying asset's price will either increase or remain stable.
This approach is commonly employed in bullish markets or when a trader believes that a particular stock or asset is undervalued. By selling the put option, the trader receives a premium upfront but assumes the obligation to buy the asset at the specified strike price if the buyer of the put option decides to exercise it.
BULLISH OR NEUTRAL OUTLOOK
A short put position is generally used when an investor has a bullish outlook on the underlying asset.
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This strategy profits if the price of the underlying asset remains above the strike price.
LIMITED PROFIT POTENTIAL
The maximum profit in a short put position is limited to the premium received when selling the put option.
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However, the potential loss is theoretically unlimited.
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If the price of the underlying asset drops significantly, the losses for the seller of the put can accumulate.
TIME DECAY BENEFITS
As time passes, the value of the put option tends to decrease, especially if the price of the underlying asset remains stable or rises.
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This is known as time decay or theta decay. Short put positions benefit from time decay, as it erodes the value of the option premium.
PROS | CONS |
Income Generation: One of the primary advantages of a short put position is the ability to generate income through the premium received from selling the put option | Unlimited Risk: The potential loss in a short put position is theoretically unlimited. If the price of the underlying asset drops significantly, the losses for the seller of the put can accumulate. |
Bullish Outlook: This strategy is suitable for investors with a bullish outlook on the underlying asset. It allows them to profit if the price remains stable or rises. | Limited Upside: While the income generated is a definite pro, the potential upside is limited to the premium received. If the underlying asset experiences a significant price increase, the seller of the put option misses out on potential gains. |
Time Decay: Short put positions benefit from time decay (theta decay), as the value of the put option tends to decrease over time, especially if the price of the underlying asset remains stable. | Assignment Risk: There's always the risk of early assignment, where the option buyer decides to exercise the option before expiration. This could happen if the price of the underlying asset falls significantly. |
Limited Profit Potential: The maximum profit is limited to the premium received when selling the put option, providing a defined and known profit potential. |
SHORT PUT AND OPTION ASSIGNMENT
In a short put scenario, assignment risk arises when the short put option gets exercised by the option holder. If the short put option is exercised, the trader who sold the option is obligated to buy the underlying asset at the specified strike price. This could result in the trader having to take delivery of the underlying shares or pay cash to fulfill the obligation.
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For short put positions, assignment risk typically occurs if the price of the underlying asset is below the strike price of the short put option at expiration.
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In such a case, the buyer of the put option may choose to exercise it to sell shares at the higher strike price.
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To manage assignment risk when shorting puts, traders can consider the following strategies:
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Close Out Before Expiration: If it appears likely that the short put will be in the money (i.e., the price of the underlying asset is below the strike price), traders can choose to buy back the put option before expiration. By doing so, they can avoid the risk of assignment and any associated costs.
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Roll the Position: Alternatively, traders can roll the position by buying back the existing short put and simultaneously selling another put option with a later expiration date and/or different strike price. This strategy allows traders to extend their position in time while potentially adjusting the strike price, thereby managing the assignment risk.
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Adjust the Position: Another approach is to adjust the position by taking appropriate action in the underlying asset or by hedging with other options or positions to mitigate potential losses from assignment.
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By employing these strategies, traders can effectively manage assignment risk associated with short put positions, ensuring they maintain control over their trading objectives and avoid unwanted obligations related to the underlying asset.
SHORT PUT EXAMPLE
Suppose an investor holds a bullish view on the SPDR Dow Jones Industrial Average ETF Trust (DIA) for the upcoming nine days. Envisioning the stock's current trade at $347.47 per share, the strategy chosen to express this bullish outlook involves the execution of a short put strategy. In this scenario:
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Sells for $1.01 one put option with a strike of $350 expiring in nine days
This strategic move results in a net credit of $1.01 for the single option, derived from the sale of the $1.01 credit. Considering the standard equivalence of one options contract to 100 shares of the underlying asset, the overall credit accumulated stands at $101.
MAXIMUM PROFIT SCENARIO
Suppose DIA experiences a downtrend, reaching $350 at the time of expiry. This results in the attainment of maximum profit, amounting to $101. This is obtained from the initial credit from the sale of the put position, and then multiplying the result by the number of shares (100). Hence, $1.01 multiplied by 100 shares equals the peak profit of $101.
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$1.01 x 100 shares = $101
It's important to note that once the stock surpasses the higher strike price, the strategy plateaus, and no additional profit accrues beyond this point.
MAXIMUM LOSS SCENARIO
Should the DIA shares hover at $350 or fall below the designated lower strike, the maximum loss comes into play. Yet, this loss will continue forever until the position is closed or assigned and then multiplied by 100 shares.
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Unlimited Potential Loss
The investor's undesirable scenario envisions the stock concluding below the $350 per share mark upon expiration, thus marking the potential loss for this investor of unlimited loss.
BREAKEVEN POINT
The breakeven point for a short put spread is calculated by subtracting the net credit received from the strike price of the sold put option.
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Strike Price: $350
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Net Credit Received: $1.01
The breakeven point of $348.99 per share indicates that if the price of DIA remains above $348.99 by expiration, the investor will realize a profit. Below this price, the investor would start to incur losses, potentially up to the maximum loss scenario where the stock price falls significantly below the strike price of the put option ($350 in this case).
The short put strategy offers investors a way to potentially profit in bullish or neutral market conditions by selling put options. This approach involves receiving an upfront premium in exchange for agreeing to purchase the underlying asset at a predetermined strike price if the option is exercised. While the strategy limits profit potential to the premium received, it exposes the trader to unlimited downside risk if the asset's price declines significantly. Managing assignment risk is crucial, and strategies like closing out positions early or rolling them over can help mitigate potential losses. Overall, the short put strategy suits traders with a positive outlook on the underlying asset and can benefit from time decay as options approach expiration. Understanding and effectively implementing this strategy can provide traders with a structured approach to generating income and managing risk in their investment portfolios.
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- Team, Cfi. “Short Put.” Corporate Finance Institute, 22 Nov. 2023, corporatefinanceinstitute.com/resources/derivatives/short-put/.
- Short Put - Uncovered (“Naked”). www.fidelity.com/learning-center/investment-products/options/options-strategy-guide/shortput-uncovered.
- Schaeffer. “How And Why to Trade Short Put Spreads.” Nasdaq, www.nasdaq.com/articles/how-and-why-to-trade-short-put-spreads.
- “The Short Option: A Primer on Selling Options.” Schwab Brokerage,” Nasdaq, 23 July 2021, www.schwab.com/learn/story/short-option-primer-on-selling-options.
- Explaining Put Options (Short and Long) - CME Group. www.cmegroup.com/education/courses/introduction-to-options/explaining-put-options-short-and-long.html.
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