Short Put
...or Short Puts
Position
Type
Strike
Expiration
Quantity
Short
Put
ATM (0)
Long term
1
         
         
         
Example:
Short 1 XYZ Oct 60 Puts.
Opinion: Bullish
  
A Put writer is an investor who sells a Put that he or she doesn’t already own.

Since the buyer of a Put has the right to sell XYZ stock at the strike price, the writer of a Put is obligated to buy XYZ stock at the strike price if assigned.

As with uncovered Calls, the risks of writing uncovered Put options are substantial. Thus, the Put writer must be financially capable of buying XYZ if assigned an exercise notice at any time during the life of the option.

Description:
The investor writing Put options should believe that XYZ is not going down! XYZ doesn’t have to go up, but it must definitely should not go down.

The maximum profit is limited to the Put premium received and is achieved when the price of XYZ is at or above the option’s strike price at expiration. The maximum loss is unlimited.


A Put writer is an investor who sells a Put that he or she doesn’t already own.

Since the buyer of a Put has the right to sell XYZ stock at the strike price, the writer of a Put is obligated to buy XYZ stock at the strike price if assigned.

As with uncovered Calls, the risks of writing uncovered Put options are substantial. Thus, the Put writer must be financially capable of buying XYZ if assigned an exercise notice at any time during the life of the option.


Writing Puts: Why?
Like uncovered Call writing, uncovered Put writing has limited rewards (the premium received) and potentially substantial risk (If XYZ falls below the strike price and the writer is assigned).

The primary motivations for most Put writers are:

  • to receive premium income; and
  • to acquire stock at a net cost below the current market value.

Tick, tick, tick...
There is a small group of investors whose only goal in writing uncovered options, Calls and/or Puts, is to collect and keep the option’s premium.

As Call writers, they have no interest in selling XYZ stock. As Put writers, they have no interest in buying XYZ.

Although both outcomes are possible, these writers simply want time to pass and their written options to decay quickly and without many surprises.


...be nimble, be quick:
It must be pointed out that this group is small not because of any lack of interested candidates, but because of a lack of successful candidates. It could be said, “While many are called, few remain!”

This type of option writer is offered limited rewards and unlimited risk.

Thus, unless you have good market timing, adequate finances, the time needed to constantly monitor XYZ and are very nimble, don’t join this group.


Writers Seeking Stock:
An option writer, if assigned, is obligated to either sell XYZ at the strike price (Call writer) or buy XYZ at the strike price (Put writer).

Therefore, because of this possibility of being assigned an exercise notice:

  • Writing uncovered Calls can be comparable to a short sale of stock.
  • Writing uncovered Puts can be comparable to owning stock.

Warning: The investor should never write a Put on a stock that he or she would be uncomfortable owning!

Also, it is important that the number of Puts written corresponds to the number of shares that the investor is both comfortable and financially capable of owning! To do otherwise, is rampant speculation.

Remember, the investor who is financially prepared to purchase XYZ is not speculating. The assignment obligating the investor to buy the stock may not be the primary goal, but it should not be a disaster if it were to occur.

Because almost all investors are familiar and comfortable with stock ownership, uncovered Put writing, if correctly executed, may be a suitable alternative to buying XYZ stock!

For example, with XYZ at $60, an investor who wants to buy 100 shares of XYZ could decide to either:

  • Buy 100 shares of XYZ @ $60, or
  • Sell 1 Oct 60 Puts @ 3 3/4.

The concept of margin is sometimes confusing for investors. For Put writers, it can be thought of as collateral for the stock that you have committed to buying if you get assigned an exercise notice. In this case, the outright purchase of 500 shares of XYZ at $60 would cost $30,000 in a cash account or $15,000 in a margin account. Notice that by writing the Put, the investor’s collateral requirement is only $6,000.

Note: The requirements stated below are for XYZ at $60. As the stock price changes, so will requisite margin (collateral) requirements.

Basic Margin Calculation for...Short 5 Oct 60 Puts @ 3 3/4 – Underlying Stock: $60

 
Basic
Margin Calculation
3.75 *5 *100=
$1, 875.00
 
$60*500*20%=
$6, 000.00
 
Total
$7, 875.00
 
Margin Requirement:
$7,875.00
Margin Call:
$6,000.00
($7,875 -$1,875)

Explanation: For an ATM option, the margin requirement is 100% of the option proceeds plus 20% of the underlying stock value. The option sale proceeds ($1,875.00) may be applied to the initial margin requirement.

Note: Brokerage firms may have higher margin requirements than the minimums illustrated.


Writing Puts vs Buying Stock:
The Put position has two potential outcomes:
  • If the stock is above the strike price ($60), the investor keeps the Put premium. ($1 875 = 3 3/4 *5*100)
  • If the stock is below the strike price ($60), the investor will be assigned and have a purchase price of $56 1/4 for the 500 shares. (60 Strike - 3 3/4 Put)

A trade-off:  
Clearly, if XYZ is below $60, the Put position is the superior choice (500 shares @ $56 1/4 vs. 500 @ $60)!

Above $60, there is a 3 3/4 point range wherein the written Put position is superior because of the premium collected from the Put sale ($1 875).

If XYZ rallies more than 3 3/4, the long stock position is superior because its upside profit potential is unlimited while the Put position has a cap equal to the initial credit ($1 875).


Bullish, but not too bullish:
The point on the upside where the two strategies are even is an important point for the Put writer to consider. Beyond this point, the Put writer suffers an opportunity cost since he or she will not profit from XYZ’s rally.

Therefore, as for any option writing strategy, the price range defined by both the financial and opportunity break-even points should encompass the investor’s expectations. In this case, XYZ is expected to be around $60 (+/- 3 3/4) at expiration.


Select Month & Strike best suited for particular opinion:
When writing Puts as part of either a stock buying campaign or in conjunction with other Put purchases, the investor should match his or her expectations and tolerance for risk with the various options available.

The investor must compare the trade-offs involved with each option to see how it fits into the overall plan.


Trade-offs:
As previously noted, the selection process is full of choices. With four or more expiration months and numerous strike prices for each month, the list of possible Put options to write is long.

One thing the Put writer should keep in mind is that ITM Puts tend to have little in the way of time value. In fact, as the Put becomes deeper in-the-money, the dollar difference between Puts with the same strike price but different expiration months narrows considerably.

Purpose: Time Decay

When constructing a position which involves writing Puts, the investor should focus on what the Put sale is intended to accomplish.

An investor who has purchased ITM & ATM four to six month Puts, might consider writing some near-term ATM or OTM Puts to offset the decay.

For example, with XYZ at $60:

Long 5 Jan 60 Puts @ 5 1/8Short 5 Oct 55 Puts @ 1 9/16

Purpose: Income #1, Ownership #2

If the primary goal in writing a Put is income with the secondary goal being stock ownership, the investor should focus on ATM or OTM Puts, The near-term Puts generate less income but also have less time to become in-the-money.

Remember, sell OTM (lower strike) Puts if neutral on XYZ. Sell ATM Puts if very confident XYZ won’t decline and is likely to rally. And sell ITM Puts for maximum profit potential in a rally.

Purpose: Stock Ownership

If the primary goal in writing a Put is stock ownership, the investor needs to define what the price range for XYZ is expected to be. The investor must select a Put whose premium will help compensate for any rally in XYZ.

Therefore, ATM and ITM Puts are the best candidates. Their premiums are much higher that OTM Puts. If XYZ is expected to have a large advance, the investor should simply buy the stock.

Analysis of various expiration months:

Pros & Cons: Near-term options
(+) The rate of decay of the option’s time premium accelerates.
(-) Writing near-term options does not produce much revenue.

Pros & Cons: Longer-term options
(+) The longer the Put option’s term, the higher its price.
(-) Rate of decay is slow and more time for a decline to occur which could create losses (possibly large).

Analysis of various strike prices:

Pros & Cons: ATM & OTM options
(+) Prices consist of all time value, decay of option accelerates as the option approaches its expiration.
(-) Smaller premiums may offer little protection against opportunity cost for stock “seeker” if XYZ rallies sharply.

Pros & Cons: ITM options
(+) Higher prices offer larger $ profits is XYZ rallies.
(-) Very little time premium. Similar to long stock position if XYZ declines.

Risk/Reward Characteristics

Break-even Point: At expiration, the break-even point (B.E.) is equal to the strike price of the Put option minus the Put option’s premium.

Example: Oct 60 Put @ 3 1/2
B.E. = Strike Price – Option Premium = 60 – 3 1/2 = 56 1/2.

Before expiration, the break-even point is higher.

Profit/Loss

Profits are limited no matter how large the advance in XYZ.

Losses are unlimited!!

At expiration, for every point XYZ is below the strike price, the Put option increases an additional point in value. For each point below the break-even point, losses increase by a point.

Time decay: Positive.

A Put option’s premium consists of both intrinsic value (if any) plus time value. As time passes, the time value portion of the Put erodes (i.e., decays). At expiration, the Put’s value will equal its intrinsic value.

Note: The rate of decay accelerates as the option’s expiration date nears.

Changes in Implied Volatility:
If volatility increases, effect is negative
If volatility decreases, effect is positive

Changes in the option’s implied volatility has an effect on the “time value” portion of an option’s premium.

Thus, a change in the option’s implied volatility has the same effect as changing (+/-) the number of days remaining until the option’s expiration.

Early Exercise of deep in-the-money (ITM) Put options:

The possibility exists that a deep ITM Put may be exercised prior to its expiration. If this occurs and the Put writer is assigned an exercise notice, the Put writer’s position will change to that of long XYZ stock.

Generally, the options with the highest risk of early exercise are the near-term ITM and deep ITM Put options right after XYZ’s ex-dividend date. Thus, all written Put options that are ITM should be monitored closely.

Equivalent synthetic position:

This strategy: Short 1 Oct 60 Put
is equivalent to Long 100 Shares of stock + Short 1 Oct 60 Call.