Short Put Options Strategy
Direction: Bullish to Neutral

Strategy Description

A Short Put Options, also known as Naked Put option strategy, involves the sale of a put option. Selling option is also known as “writing” an option.

Outlook: With a short put, your outlook is bullish or neutral.

You are not expecting the underlying stock price to drop or the volatility to increase significantly.

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Risk and Reward

Maximum Risk:

• Unlimited to the downside of the underlying stock. (May loss more than the amount of premium collected if you do not have a build in risk management feature in this option trading strategy)

Maximum Reward

• Limited to the amount of premium collected.

Breakeven

• Strike price minus premium collected

Net Position

• This is a net credit trade because you collect premium from the sale of put option

Advantages and Disadvantages

Advantages:

• Time erosion of options values help writer of put option.
• May profit from three scenarios: underlying stock price rise, move sideways, or drop by a relatively small amount.
• Require less capital than buying the stock outright.
• If done correctly, can earn regular income by trading rising or rangebound stock.

Disadvantages

• Unlimited risk to the downside of the underlying stock.
• Potentially may loss more than the amount of premium collected if the strike price, expiration dates or underlying stock are badly chosen. You should only employ this strategy to stock that you wish to own at the strike price you are willing to pay.

Exiting the Trade

• Let the short put options expire worthless and earn the full sum of premium collected
• Buy back the put options and close off the position at a profit.
• Time decay will erode the value of the option everyday. Assuming all other variable being equal, option seller (writer) will be able to buy back the option at a lesser value then what had been paid for initially.

Short Put Options Example

Assumption: XYZ is trading at $118.50 a share on Mar 20X1. You are expecting share price of XYZ to rise or move sideway. In this case, you may consider to sell one Apr 20X1 $115 strike put at $2.20 to profit from the bullish or neutral outlook of the stock. Note: commissions are NOT taken into account in the calculation.

Analysis of Short Put Options Example

Maximum Risk = Unlimited
Maximum Reward = $220 (premium collected).
Breakeven = Strike price - premium collected = $115 - $2.20 = $112.80

Selling a put is one of the simple, short term option trading strategies. Selling an option does not require you to be precise on the direction, timing or magnitude of the move and you enjoy the benefit of time decay. An option writer can also structure the short put in a way to enjoy a higher statistically probability of success than buying the stock or buying a put option.

When you short put options, it usually increases in value due to the drop in the underlying stock price or increase in volatility. It decreases in value due to time decay, a rise in underlying stock price or contraction in volatility. Therefore, to get the maximum return from trading short put options, try to ensure that the underlying stock is in an upward trend or at least range bound and also identify a clear area of support. The maximum gain is realized when the underlying stock is at or above the strike price at expiration date.

Option is a wasting asset and time decay (in your favor) accelerates exponentially in the last month before expiration. To get better trades than buying the stock itself, do ensure that you give yourself as little time as possible to be wrong. Generally this means that you should only short options that expire in less than 1 month.

One important point to take note is that if you short a put and is assigned, you will be forced to buy the underlying stock at the strike price.

However, some traders considers this as an advantage as they will be able to own the stock they wish to hold at a price they are willing to pay.

The premium collected can also lower the cost basis of buying a share.

In order not to buy a stock that is falling, select the strike price around an area of strong support.

Although this strategy is one of the simple stock option strategies to execute, shorting a put options (without any risk management features) is a risky strategy as you are exposed to unlimited losses if the stock price drop. A single loss from this strategy can wipe out a few years of profit from shorting option. Most of the brokers will only allow experience traders to trade this strategy.

You should pick the strike price and time frame of the put options according to your risk profile and forecast. Selecting the best strike price at the appropriate time frame is a balancing act between collecting as much premium as possible while keeping the risk exposed to the minimum.


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