Selling puts is a popular strategy among traders looking to profit from a security’s price sideways or bullish move. A short put, also known as a naked put, involves selling a put option, offering capped profits at high probability and potentially unlimited losses. Discover what a short put is, its payoff and the strategy behind the trad while sharing more tips through a real-market short put example.
Key takeaways
- The short put strategy involves traders selling (or writing) a put option on a security. The strategy has capped profits and potentially unlimited losses.
- Time decay is on your side when you trade short puts because it will erode the extrinsic value of the option you sold.
- The short put is a simple strategy that is relatively easy to adjust depending on different market conditions.
What Is a Short Put?
What is a short put? Often referred to as “naked put” or “cash-secured put,” the short put option is a straightforward strategy in options trading. It involves selling a put option, giving the seller the obligation to buy the underlying asset at a predetermined strike price if the option is exercised. This strategy is typically used by traders who anticipate the stock price will remain stable or rise, making it a neutral-to-bullish approach.
Here’s how it works:
- Short Put Mechanics: When you sell a short put, you collect a premium from the buyer. This premium is your maximum profit, which you earn if the option expires worthless because the stock price stays above the strike price.
- Naked Put Obligations: As the seller, you must be prepared to purchase the stock if it falls below the strike price. This can lead to significant losses if the market takes a downturn.
The potential payoff for a short put varies based on market scenarios. Here is the typical P&L of a naked put:
As you can see from the chart above,
- If the stock price remains above the strike price, the option expires worthless, and you keep the premium (therefore, your maximum profit is capped).
- If the stock price dips below the strike price, you might need to buy the stock at the higher strike price, incurring a loss offset slightly by the premium received. In other words, your losses are potentially unlimited and will accumulate in a linear manner.
Understanding the short put payoff is crucial. Visual aids, like the short put graph we added above, illustrate these scenarios, highlighting the risk and reward spectrum. In essence, the short put strategy can be profitable but requires careful consideration of market conditions and risk tolerance.
Now that you know what a short put is, we can move on to a real-market example.
A Short Put Example
Picture this as an example of a short put strategy. You’re considering opening a naked put on GM, which is currently trading at $52.73.
There are several reasons why this strategy might appeal to you. First, GM is a solid company with strong financials, scoring an impressive 9 out of 10 on our options screener. This high score suggests stability and makes you confident about the company’s future. You also believe GM is a predictable stock with no upcoming earnings events that might cause significant price drops.
If your intuition is spot-on (and that’s a big “if”), you could sell a $48.5 put option expiring in two weeks, just like our screener for options shows:
Your breakeven price would be $48.22. For this short put option to be profitable, you’d want GM to stay above this level by the expiration date. While your maximum profit is $28, it’s a profit you consider likely. Our screener indicates an 89.98% chance of the put expiring worthless, which aligns with your goal when initiating a short put.
But how do you determine the right strike price for your put? There’s no foolproof method, but a few common-sense tips can help. Consider placing your breakeven below an existing resistance threshold for GM. Over the past months, GM has struggled to exceed the $50 mark, as you can see from the chart below:
If you are into technical analysis, you’ll know that past resistances can often turn into supports. By setting your breakeven at $48.22, which is below $50, you might be making a calculated move.
Let’s break down the benefits and considerations of this short put strategy:
- Company Strength: GM’s strong financials and stability.
- Predictable Stock: No major events expected to impact the stock price significantly.
- High Probability: 89.98% chance of the put expiring worthless.
- Technical Analysis: Breakeven below a historical resistance level.
In terms of the short put payoff, if GM’s stock price remains above the strike price, the option expires worthless, and you retain the full premium. However, if the stock price falls below the strike price, you may need to purchase the stock at a higher price, leading to a loss, albeit mitigated by the premium received.
This scenario highlights the importance of carefully selecting the strike price and understanding the market dynamics. A short put graph can be helpful to visualize potential outcomes, showing the relationship between stock price movements and your profits or losses.
In summary, opening a naked put on GM can be a smart move if you believe in the company’s stability and can accurately anticipate market conditions. Understanding the factors that influence your decision, like company performance and market resistance levels, can guide you in making a well-informed choice.
Short Put – Pros and Cons to Consider
It was a bit implied within our previous example, but let us state more openly the pros and cons of the short put strategy. Here are the pros and cons of the short put strategy:
Pros
- Upfront Premium Income: Selling a short put option lets you collect the premium immediately, providing an attractive income stream if you anticipate the stock will remain stable or rise.
- Buy Stock at a Reduced Price if Assigned: If the put is assigned, you purchase the stock at the strike price, potentially below its market value, giving you a built-in discount.
- High Probability of Profit: Selecting a company with strong fundamentals and minimal expected price fluctuations increases the likelihood of the put expiring worthless, allowing you to earn consistent income.
- Success Linked to Good Company Selection: Targeting well-performing companies enhances your chances of a favorable outcome. Tools like a short put graph can help visualize the probability of profit based on strike price and market conditions.
Cons
- Unlimited Loss Potential: A sharp decline in the stock price can result in significant losses, as you may be required to buy the stock at a much higher price than its market value.
- High Margin Requirements: Short puts often require substantial margin, tying up capital that could be allocated to other investments.
- Risk from Market Volatility: Sudden market swings can quickly turn a profitable trade into a losing one, with unforeseen assignments adding financial pressure.
- Opportunity Cost if the Stock Rises Considerably: If the stock rallies significantly, your profit is capped at the premium received, missing out on larger gains that could come from owning the stock outright.
Therefore, while short put options can provide steady income and strategic stock acquisition opportunities, they demand careful risk management and market analysis. Balancing these pros and cons is crucial to leveraging this strategy effectively.
The Effects of Time Decay and Implied Volatility on the Short Put Strategy
The fate of your short put does not only depend on the price change of the underlying stock or ETF; time decay and implied volatility also play significant roles. Understanding these factors can help you make the most of your short put strategy. Let us summarize the effects of time decay and implied volatility on your short put in this table:
Time Decay (Theta)
Time decay, or theta, affects the value of a short put option as it nears its expiration date. Essentially, the option’s extrinsic value decreases over time. Options with longer durations before expiration are generally priced higher because there’s more time for the underlying asset’s price to fluctuate. As the expiration date approaches, this value diminishes, benefiting the seller.
- Benefit to Seller: As time passes, the option loses value, which is advantageous for the seller as it reduces the potential cost to buy back the put.
- Premium Decline: The closer to expiration, the less premium buyers are willing to pay, making it easier for sellers to secure a profit.
Implied Volatility (Vega)
Implied volatility reflects the market’s expectations of future price movements. This factor can significantly impact the pricing of a short put option.
- High Implied Volatility: When implied volatility is high, option prices increase due to anticipated large price fluctuations. For sellers, this means a higher initial premium.
- Volatility Decrease: If implied volatility decreases before expiration, the option’s value falls, allowing the seller to buy it back at a reduced price, maximizing profit.
Incorporating these elements into your short put strategy can enhance your outcomes. A short put graph can help visualize how time decay and volatility shifts affect your potential short put payoff.
For instance, going back to our short put example, you may want to include the IV rank of the options you are evaluating (i.e., giving preference to an option with a very high IV rank), so that you can pick an option that is likely overbought at the moment.
In summary, grasping the effects of time decay and implied volatility on short puts can make your trading more effective. By strategically choosing when to sell based on these factors, you can increase your chances of success while managing risks inherent to the strategy.
Adjusting and Rolling a Short Put
Finally, you should also consider that a good short put does not simply require good timing at the opening, but also careful management throughout the trade. Adjusting and rolling are key strategies to keep your short put option healthy and potentially profitable.
In fact, here’s a synthetic table with the main pros and cons of adjusting and rolling a short put:
Adjusting
When your short put is challenged, you can manage the trade by adjusting your position. This involves buying a put at a lower strike price, effectively turning your naked put into a bull put credit spread. This adjustment helps define your risk while reducing your profit potential to the spread width minus the credit received.
- Adjustment of a Short Put Example: Suppose you sell a $100 put for $5.00 and then buy a $90 put for $2.00. Your maximum profit is now limited to $3.00 per share (the $5.00 credit received from the sold put minus the $2.00 cost of the purchased put). However, your maximum risk is defined at $700 per contract if the asset falls below $90 at expiration.
Notice that opening a short put strategy gives you multiple ways to adjust your trade. For instance, if the stock price drops below the strike price of the put you sold, you could buy the stock at the strike price and then continue the trade as part of the wheel strategy.
Rolling
If you wish to extend the trade, rolling the short put option is a viable strategy. This process involves buying-to-close (BTC) your current short put and selling-to-open (STO) a new put option with the same strike price but for a future expiration date. Rolling should ideally result in an additional credit, which can widen your breakeven point and increase your profit potential compared to the original position.
Here are the benefits of rolling a short put:
- Increased Credit: Rolling usually adds to the credit received, providing a buffer and lowering the breakeven point.
- Flexible Expiration: Extending the expiration gives the asset more time to move in a favorable direction.
While rolling can reduce risk by adding credit, it’s important to note that risk remains undefined. Therefore, these strategies require careful analysis of market conditions and a clear understanding of your risk tolerance.
By mastering adjusting and rolling techniques, you can enhance your short put strategy, allowing for better responsiveness to market changes and optimizing your potential short put payoff.
