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Short Put

The sale of a put option

What is a Short Put?

A short put is just the sale of a put option. When you sell a put option, you are said to be short the put. A trader, when shorting a put option, sells the right to sell short the option’s underlying stock at a later date – any time before the option’s expiration – at the price outlined in the option contract (known as the strike price), and for the number of shares specified in the contract.

 

Short Put

 

When a trader uses the short put approach, his ultimate goal is to profit by the amount of the option’s premium that he or she receives, without the option being exercised. If the option buyer exercises the option, the seller is required to purchase the underlying stock at the option strike price, which will mean incurring a loss, since the option purchaser will only exercise their option if the stock’s market price declines to a price level below the strike price.

 

Summary

  • A short put is the sale of a put option; a trader sells the right to sell short the option’s underlying asset for a specified price (known as the strike price).
  • The short put writer’s goal is for the underlying asset’s price to stay at or above the strike price until the option expires; it makes the option worthless, meaning it won’t be exercised, and the premium received for the put can be kept as profit.
  • Short put options are risky because the underlying asset’s price could fall significantly below the strike price; a naked short put is riskier than a covered short put.

 

Exploring Put Options in General

Before we discuss short puts in more depth, let’s take a moment to explore put options more generally. Options contracts – both puts and calls – provide traders with the opportunity to profit from stock movements in the market. Purchasing options makes it unnecessary for traders to immediately enter an outright position in the underlying stock itself. Instead, the trader makes a limited investment in the purchase of an option, only looking to enter the market outright – through the exercise of the purchased option contract – if and when the stock’s price moves in his favor.

Some traders employ complex trading strategies that combine buying and/or selling put and call options with different dates of expiration and different strike prices, with the aim of earning a measured profit with minimal risk and minimal outlays of cash.

A call option enables the holder to purchase the underlying stock at the specified strike price. Put options are the exact opposite. A trader holding a put option has purchased the right to sell short a specified number of the option’s underlying stock shares at a specified price, up until the option’s date of expiration.

For the put buyer, the option is valuable if the price of the underlying stock dips below the strike price before the expiration of the option. The option holder already paid the seller a specified price, known as the premium, for the options contract, hoping that the asset’s price falls. The holder can then activate, or exercise, the put option, selling short the specified number of underlying stock shares for the strike price at a time when the strike price is higher than the current market price, thus earning a profit.

The put option seller, for obvious reasons, sells the option with the belief that the underlying asset’s price will remain above the strike price until the option expires. It makes the put option of no value to the holder and with no reason to exercise it. The seller then pockets the premium as pure profit, without the need to deliver shares to the option buyer.

Note: With American-style options, the option buyer may exercise their option on any trading day prior to the option’s expiration date. European-style options, in contrast, only allow the option holder to exercise their option on the designated expiration date. Thus, American-style options offer the option buyer more flexibility, whereas European style options tilt things in favor of the option seller.

 

Naked and Covered Short Puts

Short puts are may be either what is referred to as “naked” or “covered.” Of the two types of short puts, a naked put involves taking on substantially more risk. Selling short a naked put means that the option seller does not hold any other market position in the underlying asset that can serve as a hedge against potential losses from the option sale.

In contrast, a short put position may be covered by either selling short the underlying stock, by purchasing a put option, or by selling a call option on the stock. Adopting any of the market positions “covers” the short put because gains in the cover position will act to at least partially offset losses that may result from selling short a put option. A trader who sells short a put option employing such a strategy is said to be short a covered put.

As previously noted, investors utilizing short put options do so with the expectation that the underlying asset’s price will either remain above the option strike price or at least stay the same as the strike price. The selling of options contracts is considered an inherently risky endeavor, primarily utilized by skilled traders with a good read on price movements.

Naked puts are even riskier because the option sellers are putting themselves in a position of considerable financial exposure, relying heavily on the accuracy of their assessment of the underlying asset’s likely price movement before the option’s expiration.

 

Profits and Losses with Short Puts

The maximum profit on a short put is the premium that the trader receives when writing (selling) the put option. Selling options is a very attractive strategy to some investors because they receive their profit as soon as they sell the option, and because the minimal investment required is just the margin deposit they must maintain with their broker until the option’s expiration (at which time, the broker returns the margin deposit to the investor).

Let’s say, for example, that a trader writes a short put option for 20 shares of the underlying stock, and he receives a $2 premium for each share. The trader’s goal is to reach the date of the option’s expiration without it being exercised. He is then able to keep the premium payment; here, the trader would make a $40 profit.

Alternatively, if the trader’s market forecast proves incorrect, then he or she may suffer a significant loss. Let’s say that the option writer issued a $15 put strike price, and the underlying asset price drops to $10. The trader would then be required to provide the option buyer with a short position in the stock at the $15 a share level; thus, he is entering the market by adopting a market position that has a $5 per share loss.

Keep in mind, however, that the loss is partially offset by the amount of the $2 premium per share that he received for the sale of the option, so his net loss would be $3 per share. Here, the trader incurs a $100 loss from the option’s exercise – minus the $40 premium received – for a net loss of $60.

 

More Resources

CFI is the official provider of the global Capital Markets & Securities Analyst (CMSA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • Options: Calls and Puts
  • American vs Bermudan vs European Options
  • Margin Call
  • Naked Shorting

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