With the short put option strategy, the investor is betting on the fact that the stock will rise or stay flat until the option expires. If the put option expires worthless, out of the money (above the strike price), then the trader keeps the entire premium, which represents their maximum profit on the trade. When it comes to single option trades, selling a put option is one of two bull market strategies, the other being the long call option.
As seen on the graph, the seller of the short put is obligated to purchase the stock, in most cases 100 shares per contract, at the strike price A if the buyer wants to exercise the contract.
Selling a put option can be valuable to investors as it allows them to increase their income, taking premium from other traders who are betting the stocks would fall. Therefore, when using the 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.
An investor should keep a close eye on volatility levels when selling put options. The higher the volatility, the more risk to the trader, but the higher premium they receive for taking on this type of options trade.
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Short puts are used to achieve better buying prices on the overpriced stocks. Here an investor would sell the puts at much lower strike prices, at the level where the investor would prefer to buy the stock.
When to Use the Short Put Strategy
If an investor believes a stock is going to stay above a specific price point or they wish to purchase the stock at a lower price point, selling a put option should be a consideration. Here the investor will sell put options with a specific expiration date in mind in exchange for receiving a premium. If the stock stays above the strike price (the price the investor will have to buy the stock), the investor will keep the entire premium as profit.
If the stock falls below the strike price, the investor will be forced to buy the stock at that level. This is not always a bad thing. For example, if an investor wishes to buy a stock at $50, but it is currently trading $55, they could sell a 50 strike price put option contract and receive a $3 premium. If the stock continues to trade higher or fails to reach the $50 strike price, that premium is pure profit for the investor. However, if the stock falls below $50, the investor will be forced to buy the stock at that level. This, of course, is still $5 better than where they initially wanted to buy the stock. Because they also received a $3 premium when they sold the put option contract, they now have a cost basis in the stock of $47.
Selling a put option this case is really a win-win scenario, either they make a $3 to watch the stock trade higher, or they get the buy the stock significantly lower than where they initially wanted to purchase it.
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.
The short put is a good strategy; traders are either paid to buy the stock at a lower price point than where it currently trades or paid to watch the stock trade higher. Either way, it’s a win for the trader.