Short Put Trading Strategy
The short put is basically another way to describe the strategy of selling put options. With this strategy, you are essentially agreeing to buy the underlying security at a fixed price at some point in the future. If the underlying security goes up in price, then you make a profit, but if it goes down in price, then the puts you have written could be exercised.
If this happens, you will have to buy the underlying security from the holder of the contracts you have sold. Although the short put is simple in many respects, because it involves one transaction, it isn't really an ideal strategy for beginners.
For one thing, it requires a high trading level and you are exposed to a lot of potential risk. The short put is often referred to as having unlimited loss potential, but this isn't strictly true as the maximum you can lose per option written is the price of the underlying security, and that can only happen if the price of the underlying security falls all the way to zero.
Nonetheless, there's a lot of risk involved. Despite this fact, the short put can be a useful strategy to profit from small, short term price rises in an underlying security. On this page we provide more details, covering the following.
- Bullish Strategy
- Not Suitable for Beginners
- One Transaction (sell puts)
- Net Credit (upfront payment received)
- Also known as Selling Put Options, Put Write, Naked Put, Uncovered Put
- High Trading Level Required
When to Use a Short Put
The short put is a bullish options trading strategy, so you would use it when you expect a security to go up in value. Because you can only make a fixed amount of profit, it's best used when you are expecting a security to go up in value by just a small amount. You can actually also profit if the price of the security doesn’t move at all. This is because the short put involves selling options contracts and you can therefore profit from the fact that time decay reduces the value of those contracts over time.
This strategy offers you no real protection against the underlying security falling significantly in value, so you should only use it if you are confident that the security isn't likely to decrease in price.
How to Use the Short Put Strategy
This is a very straightforward trade. You simply place a sell to open order with your broker to write puts based on the underlying security you are expecting to increase in price. As you are selling options that you don’t already own, you are entering a short position on those options.
Generally speaking, you would write puts options that are close to the money and do not have a long time until expiration. By doing this, you don’t need really need the price of the underlying security to rise by much. There is less time for the price to fall, which would cost you money.
If you wanted to increase your potential profits you could write more expensive in the money puts with a higher strike price, but you would then need the security to increase more in price for the contracts to expire out of the money. You could write out of the money puts so that you could even profit if the price dropped slightly, but these would be cheaper, and you would make less profit.
Whether you choose to write at the money, out of the money, or in the money contracts is entirely up to you and there's no particularly correct way to go. At the money contracts probably offer the best middle ground, because they provide a fair profit potential and you don’t need the underlying security to move by much.
You effectively get your profits up front at the point of writing the puts. This transaction results in net credit, because you will receive money into your brokerage account for writing them. This net credit is the maximum amount that you can profit. Basically, if the puts you write expire worthless, then you have no further liability and the payment you received is all profit.
Of course, if at any point before expiration, the contracts are worth less than when you wrote them. Then you can use the buy to close order to buy them back. If you do this, then your profit will be the difference between the original credit and the amount you spend to buy them back. As mentioned above, you can increase the potential profits put by writing in the money puts for a higher net credit, but you'll then need the price of the underlying security to increase further for these contracts to expire worthless.
The risk is that the underlying security falls in price, and the puts you wrote are assigned. If this happens, you are obliged to buy the underlying security at the agreed strike price regardless of what price the security is trading at. This is why the short put is a risky strategy. If the security falls dramatically, then your losses could be quite substantial compared to the amount you received for writing the puts in the first place.
If you choose to write out of the money puts, then you could still make a profit if the price of the underlying security only drops by a little bit. However, out of the money options are obviously cheaper so you would make less from the upfront credit you receive. Because of the risks involved, we wouldN't recommend the short put for beginners and would advise that you only use this strategy if you are confident you know what you are doing.
Advantages & Disadvantages
There are definite advantages to using this strategy, but there are also a number of disadvantages too. One of the biggest advantages is the fact that you receive an upfront credit, but this is somewhat offset by the fact that the strategy will require margin, meaning that you will have to tie up capital in your brokerage account.
You will also usually need a high trading level, which will rule the strategy out for a lot of traders. It is, however, relatively simple and is often favored by traders due to the ease of use and the relatively low commission costs.
Another advantage is that it offers the potential for profit if the price of the underlying security stays the same, which makes it a good choice if you aren't completely convinced the price will rise. The potential profits of the strategy are limited though, and if the underlying security increases a lot in price, then you won't get any extra returns.
You are also exposed to potentially significant losses if the underlying security goes dramatically down in price, although you can always buy the options back if this is looking likely.
Below you will find an example of this strategy using at the money puts. We should point out the purpose of this example is purely to provide an overview of how the strategy works and it doesn't use precise prices. Commission costs haven't been included for the sake of simplicity.
- Company X stock is trading at $50, and you expect it to increase slightly in price.
- At the money puts on Company X stock (strike price $50) are trading at $2.
- You write 1 call contract (one contract contains 100 options) for a credit of $200.
If Company X stock increases to $51 (or higher) by expiration
The options will be out of the money at expiration, and therefore worthless. You'll have no further liability and the $200 credit you received when writing them will be your profit.
If Company X stock remains at $50 by expiration
The options will be at the money at expiration, also making them worthless. The $200 credit is your profit.
If Company X stock falls to $48 by expiration
The options will be in the money; therefore you will have a liability. In this case, you will have around $2 per option for a total of $200. Taking into account your upfront credit of $200, you will have roughly broken even.
If Company X stock fell below $48 then you would start to lose money. You should be aware, though, that at any point prior to expiration you can buy the contracts back. This will incur a loss if the stock has fallen in value, but it will prevent further losses from a continued fall. Remember, if you have written European style options, then they cannot be exercised by the holder prior to expiration. If you have written American style options, then the holder can exercise them at any point.
Profit, Loss & Break-Even Calculations
- Maximum profit is limited, per option written, to “Price of Option”
- Maximum profit is made when “Price of Underlying Security > or = Strike Price”
- Maximum loss is limited only by how much the underlying security can fall.
- Loss is incurred when “Price of Underlying Security < (Strike Price – Price Per Option)”
- Loss per option written is “Strike Price – (Price of Underlying Security + Price Per Option)”
- Break-even point is when “Price of Underlying Security = (Strike Price - Price of Option)”
This is a relatively simple strategy, but it does carry significant risk and is far from ideal for beginner traders. It's best used to make a quick profit from a security that you expect to increase a small amount in price within a short period of time.
It isn't a good strategy to use if you are expecting a big increase in the price of the security (try the long call instead), or if you think there's any chance that the security will drop in price.