With the short put option strategy, the investor is betting on the fact that the stock will rise or stay flat until the option expire. If the put option expires out of the money (above the strike price), then the trader keeps the entire premium.
As seen on the graph, the seller of the short put is obligated to purchase the stock at the strike price A if the buyer wants to exercise the contract.
Short puts are very useful because they allow the investors to increase their income, taking premium from other traders who are betting the stocks would fall. Therefore, when using short put strategy, the investor receives the premium, cushioning themselves from a flat market with little movement. Nevertheless, investors need to sell their puts sparingly because they are on the hook to purchase shares if the stock falls below the strike-price by expiration.
Short Puts are used to achieve better buying prices on the overpriced stocks, selling the puts at much lower strike prices, where the investor would prefer to buy the stock.
Maximum Gain = Net Premium Received
The maximum loss for a short put strategy is unlimited as the stock can continue to move against the trader, at least until it reaches zero.
The breakeven on a short put option is calculated by subtracting the premium from the strike price.
If a stock is trading $100 and an investor wants to sell a 90-strike price put for $2.0, then the breakeven would be $88.00.
If stock XYZ is trading $100 and the investor wants to buy it for the stock $90, they can sell a 90 strike-price put option and collect a $2 premium to do so. If the stock trades down to $90, they will be forced to buy the stock, which is what they wanted, and at the lower price. Plus, they got paid $2 to do so.
If, however, the stock continues to trade up or never trades down to $90, they won’t get to buy the stock, but that $2 premium they received is theirs to keep.
It’s a good strategy; traders are either paid to buy the stock at a lower price or paid just to do nothing.