Outlook: Neutral to bullish

The phrase short put simply refers to a put option that has been sold to open. There are a few different reasons why a trader might sell a put. Since the holder of a short put may be assigned when the contract moves into the money, some investors sell put options on stocks they eventually want to own. This strategy, known as the cash-secured put, allows the trader to collect a premium up front, while simultaneously offering the opportunity to buy shares on a dip.

In this discussion, however, well focus on short puts of the straightforwardly speculative nature that is, options sold to capitalize on the expectation for neutral-to-bullish price action in the underlying security.

Entering the Trade

Typically, a short put is implemented when a trader thinks a stock is likely to hold above support, but a significant rally is not expected. With Stock XYZ trading at $27.50, you notice the $25 level has held up as support consistently over the past couple of years. While the stock appears to be grinding primarily sideways for now, you decide to capitalize on support at $25 by selling a put at this strike.

This out-of-the-money put is currently bid at 0.15. Multiplied by 100 shares per contract, youll collect a total of $15 for selling the XYZ 25 put. Your ultimate goal is now for XYZ to remain at or above $25 through options expiration.

Potential Gains

Once the option is sold, youve already attained your maximum potential profit in a short put strategy. Whether the stock settles squarely at $25 or rallies up to $50 upon expiration, that $15 you collected for the sale of the option is the most you stand to make. Ideally, the stock will close somewhere at or above $25, and you can leave the option to expire worthless without taking any further action to exit the trade.

Breakeven is calculated by subtracting the net debit from the sold put strike. In this case, 25 0.15 = your breakeven point of $24.85. As long as XYZ closes at or above $24.86, then, you stand to make at least some money on the trade by buying to close the option for less than your sale price.

Potential Losses

While the profit potential on a short put is strictly limited, losses can be steep. Any move below $24.85 will trigger a loss and in the worst-case scenario, if the stock falls to zero, you might have to eat the entire $24.85 (multiplied by 100, of course, for a total possible loss of $2,485).

Alternately, if XYZ should drop below $25 at any point prior to expiration, you might be assigned. In this case, you would have to buy 100 shares of XYZ at the strike price of $25, representing a premium to the current market price. Not only have you swallowed a loss, but now youre also holding 100 shares of XYZ that you might not even want in your portfolio.

Volatility Impact

After youve sold a put option, you want implied volatility to decline. Falling implied volatility will lower the cost of your option, making it cheaper to buy back. Conversely, rising implied volatility works against the put seller, as it makes your option more expensive to repurchase.

Other Considerations

As noted previously, some put sellers may actually be hoping for assignment. By selling puts on a stock youd like to own, you can collect a modest premium while waiting for the shares to pull back to an attractive entry price. Even if the shares dont pull back, and your buying opportunity never arises, youve got the premium collected upfront as a consolation prize.

The primary risk here occurs if the stock takes a sharp, unexpected drop perhaps as the result of some negative news. If youre assigned when the shares have plummeted 10 points below your sold strike, youll certainly be questioning your short put strategy.

KEEP READING: