Short Puts
Would you like to...
- Generate income in neutral to rising markets?
- Get paid to enter "limit buy" orders for a stock you would like to own?
Many retail traders use short puts to generate income in their accounts. Short puts can also be an excellent way to acquire stock. This is a widely used strategy and is considered one of the most conservative options strategies. The position is very similar to a covered call.
Table of Contents
What is a Short Put?
Selling puts are often seen as a way to make money in a neutral market. Having chosen the strike and expiration date of an options contract, your sale is a credit and adds cash to your account. If the short put is "cash secured," which is often prudent, it means you to have enough cash in your account to purchase the stock at the designated strike. For instance, if you sold a 30 put for $1, you would have $3,000 cash in your account, in order to buy 100 shares of stock for $30 if assigned. (Note: Your broker may require short puts to be cash secured, or may have different margin requirements.)Short puts profit by the amount of the credit if the stock is above the strike price at expiration: The maximum profit is the credit that you took into your account. For example, with the stock at $31, let's say you sold the 30 put for $1. You get to keep your $1 credit if at expiration the stock is anywhere above 30. If the stock is at 29.50 at expiration, you will have made $.50, but you also will be assigned and have to purchase the stock. (This is why it's advisable to secure the put with cash.) The strategy is actually profitable down to $29, since you did get a credit. Most traders close out the position prior to expiration if they can buy back the option for a much lower price than they sold it, for instance selling the put for $1.00, and buying back for $.15.
| XYZ | Stock P/L | Short Put P/L |
|---|---|---|
| $24 | ($7) | ($5) |
| $29 | ($2) | $0 |
| $31 | $0 | $1 |
| $35 | $4 | $1 |
As you can see, using cash-secured puts can be a way to get paid to enter a limit order. In the case above, if you want to buy the stock for $30, and the stock is trading at $31, you can sell the 30 put for $1. If the stock is below 30 at expiration you will buy the stock at 30, but because of the credit, you really only pay $29.
This strategy loses if the stock price drops significantly. Below the strike price that you sold, you have the same risk as owning the stock, because essentially you do.
The value of a short put position will profit from the stock moving up, as the put loses value. The position will lose as the stock price moves down. Because implied volatility is a significant part of the premium paid for an option, if implied volatility goes down, the short put will profit and if implied volatility goes up, it will lose. Of course, this is only the case before expiration, because at expiration profit and loss is fixed. Time is on your side with a short put. You have a position with positive theta and so every day you are profiting from time decay (as long as the stock price doesn't drop significantly).
There are several potential advantages in selling cash-secured puts to covered calls. The first is that you pay one commission as opposed to two. (This assumes that you are not assigned, and don't incur the fees that would come with assignment.) Risk management is typically easier with the one position. Puts also often command higher premiums than calls and therefore offer better potential returns. The best way to analyze this is by using the comparative implied volatilities.
Let's look at a real world example. Let's say the XLF (a financial sector Exchange Traded Fund) is trading at 24.98 (which is as close to at-the-money of the 25 strike as you are going to get in reality). The 25 call is selling for $1.36 and the 25 put is selling for 1.52. Going out-of-the-money one strike, the 30 call is selling for $.89 and the 20 put is selling for $1.08. Clearly the return is better in both cases selling the put.
Example of a Winning Trade
- In the circled area, Intel's (INTC) price bounces off resistance at the same time that implied volatility spikes. We want to sell puts on underlyings with high implied volatility because there is more time decay in our favor.
- Time decay is the greatest in the front month, so in this case, with the stock at 23.50 and rising in mid-August, we would sell one month out: September 22.50 puts for $1.25.
- If the underlying price rises, and implied volatility drops (as was the case), it is best to buy back the put at some pre-determined value (say $.20). If the stock would have stayed above 22.5, however, but the put did not quickly dropin value, we could have let time-decay work for us and simply waited for expiration.
- In this case, we were able to buy back the put for $.20 before expiration. This takes out profit off of the table and eliminates risk near expiration.
Example of a Losing Trade
- Some people like to use ETFs for short puts to minimize risk, but that doesn't mean that there isn't any risk. Here is an example using the QQQQ.
- In late July, we seemed to have the price bottoming out, while implied volatility spiked. The price broke back above 48 as the implied volatility started to fall, so we sold the August 47 put for $1.20.
- After a quick move in our direction, the price dove down to below 46 as the implied volatility increased almost 50%.
- Now we had two options. We could have bought back the put for a loss. Or we could have waited until expiration, if we were still bullish on the QQQQ and didn't mind buying it at 47.
- We held the position and were assigned at expiration. QQQQ ended up just below 46 at August expiration, more than $1 below the 47 strike price that we sold.
Summary
- Short puts are a bullish to neutral strategy.
- They can generate extra income in your account.
- The risk is the same as owning the stock, minus the credit for selling the put.
- They can be a good way to acquire stock.
- They are equivalent to covered calls, but may offer some advantages.
- The maximum gain is capped, while the risk is the same as owning the stock.
Options involve risk and are not suitable for all investors. For more information, please read the Characteristics and Risks of Standardized Options. Copies may be obtained from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, IL 60606 or call 1-888-OPTIONS or visit www.888options.com.
This material is being provided to you for educational purposes only. This information neither is, nor should be construed, as an offer, or a solicitation of an offer, to buy or sell securities by OptionMonster Holdings. OptionMonster Holdings does not offer or provide any investment advice or opinion regarding the nature, potential, value, suitability or profitability of any particular investment or investment strategy, and you shall be fully responsible for any investment decisions you make, and such decisions will be based solely on your evaluation of your financial circumstances, investment objectives, risk tolerance, and liquidity needs.
Copyright © 2010 OptionMonster® Holdings, Inc. All rights reserved.
This material is being provided to you for educational purposes only. This information neither is, nor should be construed, as an offer, or a solicitation of an offer, to buy or sell securities by OptionMonster Holdings. OptionMonster Holdings does not offer or provide any investment advice or opinion regarding the nature, potential, value, suitability or profitability of any particular investment or investment strategy, and you shall be fully responsible for any investment decisions you make, and such decisions will be based solely on your evaluation of your financial circumstances, investment objectives, risk tolerance, and liquidity needs.
Copyright © 2010 OptionMonster® Holdings, Inc. All rights reserved.
