Short put

What Is Short Put?

A short put refers to an options trading strategy where an investor sells or "writes" a put option. In this arrangement, the seller receives an upfront payment, known as the premium, from the buyer of the put option. By selling the put, the investor takes on the obligation to purchase the underlying asset at a predetermined strike price if the option buyer chooses to exercise their right to sell it before or at the expiration date. This strategy is generally employed when the seller believes the price of the underlying asset will remain above the strike price, or rise, enabling them to profit solely from the collected premium.

History and Origin

The concept of options has roots dating back to ancient Greece, but modern, standardized options trading began much more recently. The true turning point for organized options markets occurred with the establishment of the Chicago Board Options Exchange (CBOE). Founded in 1973 by the Chicago Board of Trade, the CBOE was the first marketplace dedicated to listing standardized options contracts. This innovation provided a regulated, liquid environment where buyers and sellers could transact, significantly popularizing the use of options as financial instruments. Initially, the CBOE primarily offered call options, but it expanded its offerings to include put options in 1977, paving the way for strategies like the short put to become widely accessible to investors.⁹, ¹⁰, ¹¹

Key Takeaways

A short put involves selling a put option and obligates the seller to buy the underlying asset at the strike price if the option is exercised.
The maximum profit for a short put strategy is limited to the premium received at the time of sale.
This strategy is typically used by investors with a bullish to neutral outlook on the underlying asset's price.
The potential loss from a short put can be substantial if the underlying asset's price falls significantly below the strike price.
Selling short puts often requires a margin account due to the potential for significant losses.

Formula and Calculation

The profit or loss for a short put position is determined by the relationship between the strike price, the premium received, and the market price of the underlying asset at expiration.

The maximum profit is the premium received:
$\text{Maximum Profit} = \text{Premium Received}$

The breakeven point is the strike price minus the premium:
$\text{Breakeven Point} = \text{Strike Price} - \text{Premium Received}$

The profit or loss at expiration is calculated as:
$\text{Profit/Loss} = \text{Premium Received} - (\text{Strike Price} - \text{Market Price at Expiration}) \times \text{Number of Shares per Contract}$
This formula applies if the market price at expiration date is below the strike price. If the market price at expiration is at or above the strike price, the profit is simply the premium received, as the option would expire worthless.⁸

Interpreting the Short Put

Interpreting a short put position revolves around understanding the seller's market outlook and the potential outcomes. When an investor sells a put, they are essentially betting that the underlying asset's price will not fall significantly below the strike price by expiration. If the asset's price stays above the strike price, the put option expires worthless, and the seller retains the entire premium as profit. This is the ideal scenario for the short put seller.

However, if the asset's price falls below the strike price, the put option becomes in-the-money, and the seller faces the risk of assignment. Assignment means the seller is obligated to buy the underlying shares at the strike price, which is now higher than the current market price. The further the price falls below the strike price, the larger the potential loss. Therefore, a short put implies a moderately bullish or neutral market view, as significant downside movement can lead to substantial losses.

Hypothetical Example

Consider an investor who is moderately bullish on TechCo stock, currently trading at $105 per share. The investor decides to sell one TechCo put options contract with a strike price of $100, expiring in one month, and receives a premium of $3 per share (or $300 for 100 shares).

Maximum Profit: The maximum profit is the premium received, which is $300. This occurs if TechCo's share price remains at or above $100 at expiration. The option expires worthless, and the investor keeps the $300.
Breakeven Point: The breakeven point is $100 (strike price) - $3 (premium) = $97. If TechCo's stock price is $97 at expiration, the investor breaks even.
Scenario 1: Price above Strike ($100 at expiration). If TechCo is trading at $102 at expiration, the option is out-of-the-money and expires worthless. The investor keeps the $300 premium.
Scenario 2: Price below Breakeven ($90 at expiration). If TechCo drops to $90 at expiration, the option is in-the-money. The investor is assigned and must buy 100 shares at the $100 strike price. The loss is calculated as ($100 - $90) x 100 shares - $300 premium = $1,000 - $300 = $700. This illustrates the potential for significant losses if the market moves unfavorably, even though the investor initially believed the stock had positive volatility.

Practical Applications

Selling short puts is a versatile strategy with several practical applications in investing and portfolio management:

Income Generation: The primary motivation for many short put sellers is to generate income from the collected premium. If the option expires worthless, the premium is kept as profit, providing a consistent revenue stream, especially in sideways or slightly bullish markets.
Acquiring Shares at a Discount: Some investors use the short put as a means to acquire shares of a company they wish to own at a price lower than the current market value. If the stock price falls below the strike price and the put is assigned, they are obligated to buy the shares at the strike price. Effectively, their net cost per share is the strike price minus the premium received, which could be considered a discounted entry point.
Bullish Stance: The strategy reflects a bullish to neutral outlook on the underlying asset. It allows investors to profit when the stock rises, stays flat, or experiences only a modest decline, without requiring the stock to move significantly higher.
Portfolio Diversification: For sophisticated investors, incorporating strategies like short puts can add another layer to their risk management by generating income independent of direct stock ownership. However, options trading carries inherent risks and is subject to specific regulatory oversight. For instance, the Securities and Exchange Commission (SEC) provides guidance and rules for options trading, emphasizing the need for investors to understand the associated risks.⁶, ⁷

Limitations and Criticisms

While potentially profitable, the short put strategy has significant limitations and criticisms:

Unlimited Downside Risk (Below Zero): The most critical limitation of a short put is the substantial downside risk. If the underlying asset's price falls drastically, theoretically down to zero, the seller's loss can be considerable. The loss extends from the breakeven point down to the asset's price (multiplied by 100 shares per contract), minus the premium. This means losses can far exceed the initial premium collected.⁴, ⁵
Margin Requirements: Due to the unlimited risk, brokerage firms require investors selling naked puts (puts without holding a short position in the underlying) to maintain substantial margin in their accounts. This capital is tied up and could be subject to margin calls if the position moves against the seller.
Limited Profit Potential: The maximum profit for a short put is capped at the initial premium received, regardless of how high the underlying asset's price rises. This contrasts with long stock positions, which have unlimited upside potential.
Assignment Risk: The seller faces the risk of assignment if the option is exercised, forcing them to buy shares at an unfavorable price. This can happen unexpectedly, especially around dividend dates or earnings announcements.
Market Volatility and Option Greeks: Changes in market volatility, time decay (theta), and delta (the sensitivity of the option price to changes in the underlying asset's price) constantly affect the option's value, requiring active management. Academic research has explored whether selling options consistently provides an edge for risk-averse investors, with some studies suggesting the benefits are conditional and subject to market frictions and other factors.³

Short Put vs. Long Put

The short put and long put are diametrically opposed strategies within the derivatives market, reflecting differing market expectations and risk profiles.

A short put involves selling a put option. The seller receives a premium upfront and is obligated to buy the underlying asset if the option is exercised. This strategy is profitable if the underlying asset's price remains above the strike price or rises. The maximum profit is limited to the premium, while the potential loss can be substantial if the asset's price falls significantly. The short put expresses a bullish to neutral view on the underlying.

Conversely, a long put involves buying a put option. The buyer pays a premium and gains the right, but not the obligation, to sell the underlying asset at the strike price. This strategy is profitable if the underlying asset's price falls below the strike price. The maximum loss for a long put is limited to the premium paid, while the potential profit is substantial as the underlying asset's price falls. The long put expresses a bearish view on the underlying.

The confusion between the two often arises from the term "put" itself. It is crucial to distinguish between buying a put (long) and selling a put (short) because their risk-reward profiles and directional biases are inverted.

FAQs

What happens if the stock price goes to zero after I sell a short put?

If the stock price goes to zero, the put option will be deep in-the-money, and you will be assigned. This means you are obligated to buy the shares at the strike price. Your loss would be the strike price multiplied by 100 shares (per contract), minus the premium you initially received. For example, if you sold a $50 strike put and received $2 in premium, and the stock went to $0, your loss would be ($50 - $0) * 100 - $200 = $4,800.

Is selling short puts risky?

Yes, selling short puts is considered a high-risk strategy, especially if they are "naked puts" (not covered by a short position in the underlying asset or other hedging strategies). While the profit is limited to the premium received, the potential for loss can be substantial if the underlying asset's price falls significantly below the strike price.¹, ²

Why would someone sell a short put?

Investors primarily sell short puts to generate income from the premium received. It's a strategy employed when they have a bullish to neutral outlook on the underlying asset, believing its price will stay above the strike price. It can also be used as a way to acquire shares of a company at a desired price, anticipating assignment.

How does margin work with short puts?

When you sell a short put, your brokerage firm typically requires you to deposit and maintain a certain amount of capital, known as margin, in your account. This margin acts as collateral to cover potential losses if the trade moves against you. The exact margin requirements vary by brokerage and the volatility of the underlying asset. If the stock price drops, you might face a "margin call," requiring you to deposit more funds.

Do short puts benefit from time decay?

Yes, short puts benefit from time decay, often referred to as "theta." As the expiration date approaches, the extrinsic value of an options contract erodes. Since the seller of a short put receives the premium (which includes extrinsic value), this erosion of value works in their favor, making the option less valuable and increasing the likelihood it will expire worthless. This is a key component of the Option Greeks that traders consider.