When a trader opens an options trade by selling or writing a put option it is known as a short put. A Short Put is a bullish trading strategy and it is also called an uncovered put or naked put. In this strategy, the investor’s perspective is that the price of an underlying will not move below a certain level and is believed to be of low-profit potential while exposed to unlimited risk. As a strategy, it involves going into a single position of selling a put option.
When using a short put strategy, investors bet on the fact that the stock will rise or stay flat until the option expires. The trader keeps the entire premium, which represents their maximum profit on the trade when the put option becomes worthless and out of the money i.e., above the strike price. Selling a Put option is one of the two bull market strategies while the other one is the long call option among single option trades.
This strategy is valuable to investors as it increases their income by taking premiums from other traders who are betting the stocks would fall. So, when applying the short put strategy, the investor receives the premium, safeguarding themselves from a flat market with little movement. Be that as it may, investors have to sell their puts occasionally as they would be on the hook to purchase shares if the stock falls below the strike price by expiration.
When selling put options, investors should closely monitor the volatility levels. There is more risk to the trader due to the higher volatility level, however, they receive higher premiums for taking on this type of options trade. Short puts can help in achieving better buying prices on overpriced stocks. Investors would prefer to sell the puts at much lower strike prices and at the level where they would prefer to buy the stock.
How a Short Put Works?
As an investor when you expect the underlying asset to rise moderately then the short put strategy is best to use. If the underlying asset remains at the same level, it would still be beneficial since the time decay factor will always be in the investor’s favour as the time value of the put starts reducing over a while as investors reach near expiry. As it gives you upfront credit which helps in offsetting the margin, this is a good options strategy.
When a seller writes a put option contract, a short put position is initiated. Under the options chain, the listed put options not only provide the required information on every strike price and expiration available but also the bid and ask price. The premium is the credit received at the trade entry. Multiple factors to assess the option premium's value, and volatility, including the strike price relative to the stock price, and time until expiration are taken into consideration by market participants.
Example of a Short Put
Let’s discuss the Short Put strategy with an example. Imagine a bullish investor trading on the stock of XYZ company. Now, XYZ company is trading at Rs 500 per share but the investor who has a bullish approach and perhaps some insight into the stock believes that the share of XYZ will rise to 600 in a few months. Supposing the investor would take a general action of investing in the stock and wishes to buy 1000 shares then she needs Rs 5,00,000. If the investor does not have this amount liquidly available, then a put option will help in generating income for her immediately but it could also lead to significant potential losses in the future.
Now let’s assume as an investor you write a put option of Rs. 525 expiring in 3 months at Rs 50 then your maximum gain is now limited to Rs 5,000 (Rs 50 x 100 shares) and this will happen if the price closes at the strike price of Rs 525 or higher at the time of expiration. That said, the maximum loss can be much higher i.e., Rs 47,500 [(Rs 525 - 50) x 100 shares]. The maximum could likely occur if the underlying value falls to an absolute zero and the put writer is assigned to buy the share at Rs. 525 per share. The losses are partially offset by the premiums received from selling the option.
Given the function of a Short Put option strategy, it is imperative that as an investor one should have adequate knowledge and research including technical and fundamental analysis skills when placing a short put or trading in options. In this strategy, an investor has limited potential upside and a much larger potential downside if the purchased option falls below the strike price.
Short Put Mechanics
Selling a put to initiate an options trade is way different from buying an option and then selling it. A trader who is initiating a short put would always like to believe that the asset’s price will remain above the strike price. If the option will expire as worthless when the price of the underlying stays above the strike price and this, in turn, gives the writer to enjoy the premium. Conversely, if the price of the underlying falls below the strike price then the writer may face potential losses.
Risks of Selling Puts
The potential losses that can be incurred in the trade of short puts are unlimited. The risk exists when the price of the underlying falls and the put is exercised, the investor becomes obliged to buy the underlying at the strike price.