Short Put Options Strategy Explained (Simple Guide)
If you’d like to buy a stock at a lower price than it’s currently offered on the market while getting paid to wait until it drops, then you should consider a short put strategy.
A short put can be confusing because you’re short an option that people naturally view as a short position anyway. Traders who purchase put options expect the price of the underlying security to go down.
When you’re short a put, though, you’re expecting the exact opposite. You want the underlying stock to increase in value.
In fact, if the stock drops significantly below the strike price, you could lose a lot of money.
However, if the stock stays above the strike price, you stand to make a nice profit.
In this guide, I’ll explain the short put strategy in detail so you can determine if it’s right for you.
What Is a Short Put?
A short put, or naked put, involves selling a put option for an immediate credit.
That credit, by the way, is your maximum profit for the trade.
You’ll get to keep that profit if the price of the underlying stock stays above the strike price at the time of contract expiration. That’s because the option will expire worthless.
On the other hand, if the price of the underlying stock drops below the strike price at contract expiration, the person on the other end of the trade will exercise his or her right to sell you the shares of stock. You’ll have to buy them at the strike price.
Please note: you’ll have to buy them at that price no matter what they’re trading for on the open market.
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That means if the price of the stock falls all the way to $0 per share, you’ll have to purchase shares at the strike price. You would be looking at a very steep loss in that situation.
So be careful with this strategy. You could easily wipe out the value of your portfolio if the stock moves in the wrong direction.
When Would You Use a Short Put?
One of the best ways to use a short put is if you’ve got a stock on your radar that’s trading at a little bit too high of a price right now.
In that case, you’d sell the put option at a strike price that’s your target price for the stock. If the stock falls below that price at contract expiration, you’ll have to purchase the shares at the strike price, but that’s okay because you wanted to purchase shares at that price anyway.
You could also use a short put when you’re generally bullish on a stock.
How Does a Short Put Work?
First of all, make sure that you have a margin account established with your online brokerage. That’s because you’ll need to use cash to purchase the shares if the stock drops in value.
Once you have a margin account, find a stock that you think won’t go down in value in the short term. Alternatively, find a stock that you’d like to purchase for a few dollars a share cheaper than what it’s currently trading at right now.
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Then, pick a contract expiration date. It’s often the case that options traders pick a date that’s 1-3 months out.
Once you’ve settled on the strike price and expiration date, it’s just a simple matter of selling the put option. You’ll get an immediate credit.
Then, wait it out until the contract expires. Hopefully, the stock closes above the strike price and you keep the credit.
Real Life Example Using a Short Put?
Let’s say that Caterpillar is currently trading at $130 per share. You think it’s going to go up over the next month so you decide to open a short put position.
You sell next month’s $130 strike price put option for $5.66. That means you get an immediate credit of $566 because options are traded in blocks of 100 shares ($5.66 x 100 = $566).
There’s nothing more for you to do except to wait and monitor the trade.
If, as you expected, Caterpillar stays above $130 per share at the expiration date, the option expires worthless and you keep the entire credit. That’s a $566 profit, minus commissions, that goes straight to your bottom line.
On the other hand, if Caterpillar drops to $129 per share at expiration, then you’ll need to buy the shares of Caterpillar at $130 per share.
Alternatively, if you see that the price is already below $130 per share near expiration, you can buy back the put option to close it out.
Let’s say that Caterpillar ends up trading at $129 per share just a couple of days before expiration and the $130 put option is trading for $1.35. You buy back the put option for $135 ($1.35 x 100) and close out the position.
You don’t need to buy the shares of Caterpillar in that case because the short position is closed.
You still make a profit, though. You earned $566 for the sale of the put and paid $135 to buy back the position. Your total profit is $431 ($566 – $135).
However, if the price of Caterpillar dropped all the way down to $100 per share, you’d have to buy back the position for over $3,000. That would be a big loss.
What Are Similar Strategies Related to Short Put?
Here are a few strategies related to a short put:
- Long Call – Involves buying a call option on the open market. It’s similar to a short put because you only trade a long call if you expect the underlying stock to go up in value.
- Short Put Ladder – Involves selling one in-the-money put option, buying one at-the-money put option and buying another out-of-the-money put option. It’s a good strategy if you think the underlying stock will bounce around in the near term.
- Short Put Butterfly – Involves selling one in-the-money put option, buying two at-the-money put options, and selling one out-of-the-money put option. It’s another limited risk, limited profit strategy.
Short Put Compared to Other Options Strategies?
Unlike many other options strategies, a short put isn’t a vertical spread. That means you can suffer a significant loss.
Why? Because when you open a spread, your losses are limited by the extent of the spread (the difference between the two strike prices). You don’t have any such limit with a short put.
Of course, the downside of vertical spreads is that they also limit your gain.
Short puts offer limited gain as well. The credit you receive when you place the order is your maximum gain.
Your loss, on the other hand, is only limited by the current price of the stock. If goes all the way down to $0 per share, then you’re on the hook to buy that stock at the strike price. That could result in a catastrophic loss.
A short put is definitely a strategy for advanced options traders. Do quite a bit of practice trading before you open a position with real money.
Advantages & Risks of Short Put?
- Significant returns – A short put can give you significant returns in the near term. That’s because options use leverage.
- Immediate return – When you open a short put position, you get your maximum profit right away. That’s helpful if the time value of money is a concern.
- Significant loss – If the underlying stock drops significantly, you’re going to take a huge loss. It might be best to hedge a bit by purchasing a put option at a much lower strike price.
- Margin wipe-out – If the stock does drop quite a bit, you might have to purchase it and then sell it for a loss. As if that weren’t bad enough, the fact that you have less cash in your account means your available margin funds will likely drop as well.