Short Put Option Explained

In this video, we’re going to talk about the short put option strategy. As always, we’ll get right into it here. We’re going to first take a look at the market outlook as we always do when we look at different options strategies here.

Now as you know, the naked put write is also called a cash secured put in case you're writing it in an IRA or a retirement portfolio. But as a trader, you're expecting a steady rise in the stock price during the life of the option, and you consider the likelihood of a decline very remote.

Now, how conservative you get is something that we’ll talk about later on in this video tutorial. But think about option selling and particularly, put option selling like selling insurance on a stock. The only real goal for writing an uncovered put or selling a naked put is to earn the premium as income.

I'll use the analogy that I always use, and it’s the analogy that was taught to me. It's like selling insurance on a house. If you own a house or later on you might own a house, you’re going to buy insurance in case the house burns to the ground that the insurance company is going to pay up big time to help you rebuild that house.

Now for that protection, you're going to pay the insurance company a premium every single year. And if your house never burns to the ground, then the insurance company keeps that premium.

That's their income for the protection that they’re giving you. Well, selling a put is just like that for a house. You sell insurance on a stock. You protect investors from the strike price all the way to zero. And for that risk, you take on some premium as income.

How do we set this up? These are very easy to setup. It’s just a single leg option. You simply go into your broker platform, and you initiate an order to sell a put to open, you sell it right at the strike price and the expiration period that you desire.

You can sell this front month, meaning the next expiration period. You can sell them close to the market, far away from the market.

Obviously, the closer you get in expiration period and the further away you get, then it will change the premium that you receive because it changes the risk-reward profile of the option strategy. Like I said here, the more conservative you are, the further out of the money you can sell the put option.

What's the risk with this particular options strategy? Well, the maximum theoretical loss is limited, but it's very substantial. In theory, there is a limited loss, the worst that can happen is for the stock price to fall all the way to zero, in this case, the investor would be obligated to buy a worthless stock at a strike price.

When we talk about option selling, we are actually on the obligation end of an option. If you’re an option buyer, then you have a choice, you have an option. If you’re an option seller, (whether it's a call or a put) you’re on the obligation end, and it's up to the other party if they want to exercise that obligation.

If the stock were to fall all the way to zero, then we’d still be obligated to buy the stock at the 45 strike price which is where the option pivots in my particular chart here, so we’d be buying a stock that's worthless at $45 a share.

You can see this is a very real threat to individual stocks. Individual stocks overnight can gap lower. Do I dare even mention Netflix, Bear Stearns, Lehman Brothers, etcetera?

There’s a very real risk, but not so much for indexes and commodities which are why I tend to favor these on those because the S&P 500 index can never really go to zero. It's made up of 500 individual stocks, so all 500 stocks would have to go to zero.

Commodities really could never go to zero. They have some value in the marketplace like oil and gold and silver. The profit potential like we talked about earlier is just the premium that you took in during the sale of the put option.

Just like an insurance company that gives you the policy to protect your house against fire, you are only going to give them that premium for the entire year. They don't ask for any more money if you negotiate a single premium.

Just like that with option selling and put selling, the maximum gain is the premium you took in. The best case scenario is for the stock price to be anywhere above the strike price at expiration.

In that case, the option expires worthless, and you never have to do anything to close the trade, you just keep that money. And that's where some commission savings come into play.

When we talk about volatility, we are short an option. Generally speaking, an increase in volatility would have a negative impact on this strategy, everything else being equal.

Remember that volatility tends to boost the value of options, and since we want the value of our option to go to zero by expiration, a big move in volatility can be harmful because then, the stock can swing in bigger chunks and can swing outside of our profit target, so we want low volatility, minimal movement in the underlying security or stock.

Remember that at the money options will have different volatility characteristics and will behave much differently than out of the money.

If you sell an option right next to the market and right at the money, then that will behave completely different than if you sell an option that says $20 or $30 away from the market.

When we get into time decay, time decay is one of our strongest assets when we’re talking about put selling. The passage of time is really what creates the opportunity for this strategy and is therefore very positive for short puts.

Remember that we want the option to expire worthless, so every day that passes and we can get some really good time decay on these strategies is money in our pocket. The closer we get to expiration without the stock moving beyond the strike price, the better.

As the expiration approaches, the option moves towards its intrinsic value. As it becomes an out of the money put, that intrinsic value is zero.

If we never have to pay any money on our insurance contract, (going back to our insurance analogy) then we get to keep all that money, so every day that we get closer to that expiration day of that insurance contract is better for us.

When we talk about breakeven points, (this is very easy to calculate with this particular strategy) it breaks even if the stock price is equal to the strike price minus the initial put received.

Anything above this level at expiration is in towards your maximum profit. Let's say we have a 45 strike put here that we sold. We take the strike price, we subtract the premium that we received, and that is our breakeven price.

We got the premium, and we have to move that down the scale to see where our breakeven price is. Again, very easy to calculate with short puts. Let’s look at an example just to drive home the point. We have a stock price that’s trading at 50 right here on our chart.

We’re going to sell one 45 put and take in a credit or a premium of $200. Now just quickly, let's flip this around and say we were going to buy this 45 put option. We’d be outlaying that $200 to buy the option, but since we’re on the other end of the trade, we’re selling that option for a $200 credit.

Immediately, that comes right to your account, so you get a $200 credit. Now, the maximum loss is practically unlimited to the downside. If you choose a stock that’s highly volatile and it just absolutely falls to pieces, then you do have a huge loss.

Now, if you do this on an index for example, then your losses are much, much more capped in theory because they're not going to go to the downside. An index can never close all the way down at zero.

It’s made up of securities. Same thing with commodities like gold, oil, silver. Your maximum profit again is your $200, so it's just the premium that you took in. If you took in $500, your maximum profit would be $500, whatever the case is.

Now, you can buy this back later on during the cycle. You can buy another option back and create some profit. Let's say that you sold it for $200 and further on down the road, you see that this has decayed down to a value of $100.

You could go back in and buy one 45 strikes put, reversing your trade whereas you were short one put option, you now want to become even or neutral, so you create a reversing order and buy that putback, and you pay $100 because remember, the value right now is $100.

You’re going to sell it at $200 and buy back later at $100. This is a good opportunity to close out the trade early and take in some really good gains. Some of my tips and tricks regarding put selling and naked put selling.

Short puts are bread-and-butter of my personal options trading plan and have been for years and years when I talk about this, six to seven years now. They sound dangerous on the outside, but in reality, option buying is much, much more dangerous.

What I do is I sell deep out of the money puts. I sell puts that are very far from the market, 20%, 30% away with historical probabilities of expiring worthless between 90% and 95% and you can get these percentages right on your broker platform.

I avoid selling close to the market. The closer I get to the market, I do get more premium, but it also becomes riskier. And if done properly, put selling can be a non-directional strategy for monthly income. I've been doing it for years. You can check my performance.

I’m 100% open and honest with all the trading that I do here on the website, and this is my bread-and-butter strategy, and it is one of the basic building blocks of other strategies that I’ll talk about in different videos.

As always, I hope you guys enjoy this video and thanks for watching. If you like the video, please share it right below here with any of your friends, family or colleagues on your favorite social network.