Short Put, is technically defined as an options trading strategy that is used by investors on an assumption that the stock will increase or stay steady until the option expires. If the put option perishes valueless, then the trader holds the entire premium, which refers to their optimum profit on the trade. However, in the case of single option trades, selling a put option is one of two bull market strategies, the other is the long call option.
Selling a put option can sometimes be quite helpful to investors as it permits them to augment their income, obtaining premium from other traders who are gambling the stocks would decrease. Thus, when employing the short put option trading strategy, the investor gets the premium, stifling themselves from a plane market with little shift. Moreover, investors need to sell their puts frugally because they are on the knob to buy shares if the stock goes below the strike price before it expires.
In order to get desired outcomes, it is highly recommended for investors to stay wary of changing levels while selling put options. The more the unpredictability, the more risk to the trader, but the higher premium they get for opting for this type of options trade.
Short puts are employed to attain better buying prices on the overpriced stocks. Here an investor would sell the puts at much lower strike prices, at the level where the investor would prefer to buy the stock.
Short Put Details
The short put option trading strategy is also known as naked put or uncovered put. Under this strategy, an investor doesn’t need to buy the shares or assets before putting a put option on them.
For investors looking to practice the option, the seller needs to purchase the securities at higher prices and sell to the buyers of the put option. The foremost purpose of this exercise is to make the option expire valuelessly. Meanwhile, the investors earn money through premium and thus the profit.
In this case, the maximum profit can be capped at the premium procured.
One downside of this strategy is that losses can be beyond explanation. When the prices dip, the option strategy is followed and an investor buys at a higher price, also referred as strike price, and sells at a reduced price, meaning the existing price.
What is the right time to go with Short Put Option?
According to trading experts, the most preferred time to deploy a short put option strategy is when the trader is optimistic towards the market and experts the prices to go up intensely. This is when a trader sells the stock at a reduced price and earns a premium on it.
In another case, if the stock price goes beyond the strike price of the put option, the option gets expired worthlessly and the trader receives the premium. Do keep in mind that the maximum limit on the profit is the amount of premium received.
If the price dips below the strike price of the put option, a short put option is practiced by the buyer. The seller will be forced to buy the shares at a higher price and sell them at less price, facing a loss. Do remember that there is a limit on the loss incurred which may increase against the reduction in the price of the asset.
When this strategy is successful?
The short put options trading strategy is largely termed as a limited profit and unlimited risk strategy. It is primarily used by the traders when they hold up several positions and keep securing the premiums. The incurred losses can be compensated by the premiums received.
An example
If an investor wants to buy a stock at $100, which is presently trading $125, they could sell a 50 strike price put option contract and get a $20 premium. If the stock continues to trade higher or unable to attain the $100 strike price, that premium earned is absolute profit for the investor. However, if the stock goes below $100, the investor will be compelled to buy the stock at that price. This is still $25 better than where they originally wished to buy the stock. Since they also got a $3 premium when they sold the put option contract, they now have a cost basis in the stock of $47.
Selling a put option under this scenario is truly a win-win deal, either they make a $20 to watch the stock trade higher, or they choose to buy the stock meaningfully lower than where they originally intended to buy it.
Profit/Loss
Maximum Profit = Total Premium Received
The maximum loss for a short put strategy has no limits as the stock can choose to shift against the trader, until it becomes zero.
Breakeven
The breakeven on a short put option is measured by deducting the premium from the strike price.
If a stock is trading $100 and an investor wants to sell an 80-strike price put for $5.0, then the breakeven would be $75.00.
Another example
If stock ABC is currently trading $120 and the investor wants to purchase it for the stock $110, they can sell a 110 strike-price put option and get a $5 premium to do so. If the stock trades down to $100, they will be compelled to buy the stock, which is what they were looking for, and at the lower price. Also, they got paid $5 for the same.
If, however, the stock continues to trade up or never trades down to $100, they won’t get to buy the stock, but that $5 premium they got is for them to hold.
The benefit of Short Put
The strategy is great for traders who want to have a steady income in the form of the premium received until the market remains aggressive or flat.
The disadvantages of Short Put
- First, the risk potential under this strategy is extremely high which may keep increasing against the decline in the price
- There is an optimum limit on the profit in the form of the amount of premium received
In a nutshell
When it comes to the applicability and profitability of the short put strategy, the traders need to be very cautious as it has a low-profit scope and high-risk potential.
If traders are sure of the stock prices to go up, they can expect to get steady income in the form of earned premiums. On the other hand, if they are not sure of the market’s bullish response, it is better not to use short put strategy as it may result in huge losses.
For more details and expert guidance on the use of short put strategy, leave a comment below.