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Short put stock option trading strategy

 

What is a short put?

 

 

There are various reasons why a trader or an investor would write (sell) a Put option contract.

 

One reason might be that he or she actually wants to take ownership of the underlying shares of stock, but a the same time believes that the shares might be overvalued.

 

In this case one might decide that instead of just waiting for the stock to retract, he or she would sell a Put option contract instead. This way the investor can collect premium while waiting on the sidelines.

 

If assignment should occur the investor would be receiving the underlying shares at a discounted price. The premium received from the put sale would in effect reduce their cost basis on owning the actual shares of stock.

 

Another reason why one might sell a Put option contract might be as an alternative way to capitalize if a upward move of the stock should occur, via collecting premium.

 

The further the underlying stock rallies up and away from the Short Put's strike price, the option contracts value continues to deteriorate. This has a positive effect for the seller of a Put option contract. It is important to remember that when you are short Put options, you want the option contract to loose value so the option will either expire worthless therefore collecting the entire premium or you can close the position for a significant profit.

 

It is also important to understand that the passage of time has a positive effect on the Short Put option position. Every day that passes by further erodes the premium of the option contract.

 

(Theta is very important regarding the purchase and selling of option contracts).

 

The chart above is an illustration of the following example.--

 

~Sell 1 50 strike put option contract @ $15.00 bid.

 

~Total credit excluding commission=

$1,500 ($15.00x100).

 

~Strike price= $60.00

 

~Breakeven point at expiration=

strike price ($60.00)-

net credit received ($15.00)=$45.00

 

Maximum profit= 1,500

Maximum loss= 4,500

 

 

This example illustrates holding the short put option position through the option contracts expiration cycle. Remember, at expiration, all that is left in a put options premium is the intrinsic value of the said option contract.

 

As an option seller you are obligated to take the shares of the underlying at any time if assigned. Although many traders and investors might consider closing the strategy early if it is nearing expiration and the stock is still above the short put.

 

Also notice how your maximum loss on the trade is 4,500. This is because a stock can theoretically go to 0. This is also the amount that may need to be held in cash by your broker, just in case an assignment occurred and you had to receive the underlying shares.

 

The short put option strategy allows much opportunity through. Through the proper risk management, knowing the reasons why you entered the trade, as well as your exit strategy, combined with the ability to make the necessary adjustments, one will be well on their way to trading short put options profitably.