Short Put Strategies
Let’s say you have a bullish outlook on a security and would like to earn some income by collecting a premium. Or maybe you want to possibly buy a security for less than its current market value. In either case, writing a short put may be a useful strategy.
When you short a put option, you receive a premium for taking on the obligation to buy shares of the underlying stock at the strike price.
Shorting Put Options: Basics of Shorting Put Options
You've likely encountered a situation where you find a stock you would like to invest in but a recent run up in price makes you question whether it is overvalued. You tell yourself that you'd buy it if the price drops a percent or two. Maybe the stock does not come back to your target and you miss out on an opportunity.
This may be a situation in which you could consider selling short or writing a put option rather than placing a stock buy limit order. The short put may allow you to get in at a lower price, while providing some income if the stock price trades flat or continues to rise.
Here's how it works:
When you short a put, you take on the obligation to buy shares at the put option strike price for a fixed period of time.
This can occur if the stock price falls below the put strike price prior to or at the expiration of the contract. While this fits with a goal of buying the stock if it were to drop to a target price, there is a high risk of purchasing the stock at the strike price when the market price of the stock will likely be lower and the price of the stock could continue to fall. If the stock does not fall below the put strike price of the contract, then the contract will likely expire worthless, and the put seller keeps the premium received.
Let's look at a hypothetical example. Company XYZ just came out with the latest and greatest widget. The price of the stock soars from $85 to $100 after the announcement. You want to buy the stock but feel that the price has gone too high because of the hype around the widget. You'd be willing to buy the stock for $95.
The following are quotes for XYZ put options.
The put contract obligates the put seller to buy the shares of stock at the strike price. On the surface you'd think you should look to the $95 strike price put. However, you need to take into consideration the $2 premium received when selling the put. The table shows that selling the $97 strike put for $2 gives you an effective buying price on the stock of $95.
Let's look at the profit/loss diagram to graphically parallel selling the $97 strike put compared to buying the stock. The blue line represents the profit or loss of a stock-only position, and assumes you buy the stock at $100 per share. The yellow line represents the profit or loss of a short put position.
This illustration is hypothetical and does not reflect actual investment results, transaction costs, or guarantee future results.
If the stock price falls below $97 prior to or at the contract expiration, you will be obligated to buy shares of stock for the $97 contract strike price. The effective purchase price on the shares is $95 since you received a $2 payment up front. At $95 per share, you have the same downside risk of stock ownership and the stock price could drop to zero. This is evident by the parallel yellow and blue lines.
If the stock price stays above $97 through contract expiration, the owner of the contract would not exercise the contract since he would able to sell the stock at a higher price in the open market. The contract would expire worthless. This leaves the put seller with a $2 profit from the premium received. Of course, the seller would not own the stock, and would not profit from the increase in the price of the stock.
This illustration is hypothetical and does not reflect actual investment results or guarantee future results. For the sake of simplicity, tax considerations and transaction costs (commissions, contract fees, exercise, and assignment fees) are not included. If adjusted for transaction costs, profits would be reduced and losses would be increased.
How to Do it
You are able to sell short or write a put if your account is approved for the appropriate level of option trading.
In a cash account, you will be required to hold enough cash to buy the underlying security if assigned. The typical option contract represents 100 shares of stock, so in the example above, you have been required to hold $9,700 ($97 x 100). This cash cannot be used for other account activities until the short put position is closed.
In a margin account with full options trading approval, you can short a put with an uncovered or “naked” margin requirement. This requirement is typically much less than the cash-secured requirement, but you have the same obligation to buy shares for $97 per share. Margin leverage increases purchasing power and possible rate of return, but it can also expose you to higher losses.
Additionally, the margin requirement will increase if the stock price drops. This could lead to a margin requirement greater than the equity in your account (margin call). Such situations will require you to deposit more money, close the position or force the sale of other securities in your account. Trading naked options has a higher level of risk and requires a greater level of expertise and attention. It is not suitable for all investors.
Options contracts are affected in ways that might be unfamiliar to stock traders. It is important to keep these things in mind when trading short puts.
- You are not required to hold the put until the expiration of the contract. You are able to buy to close the short put position at any point prior to the contract expiration or exercise. A buy-to-close trade would require you to pay a premium to close your obligation (just as you had received a premium when you sold to open the put). The profit or loss on the trade will be the difference between the premium you received when you sold the put to open, and the premium you paid when you bought it to close, less commissions and fees.
- The put is not guaranteed to be assigned to you if the stock drops below the put strike price. In other words, you won't necessarily have to immediately buy the stock if the market price falls below the strike price. Contracts typically are exercised by long put holders at or near the expiration date; however, early assignment can happen. This is an important difference from a limit buy order for the stock. The stock could drop below the strike price and then rally above it prior to the contract's expiration and the contract may not be assigned. This would leave you without a long stock position. In that case, you will need to buy to close the put position first and then buy the underlying stock if you still wish to buy the underlying security prior to expiration of the put.
- The price of the put is affected by factors other than just the underlying stock price, including time until expiration and expected volatility. Option prices tend to decrease if expected volatility decreases and rise if expected volatility rises. The option price will also tend to decrease as the expiration approaches. This affect is called time decay and the price erosion typically accelerates as expiration nears.