Selling single options is considered “naked” because there is no downside protection if the stock moves against the position. Selling a naked put option is a levered alternative to buying shares of stock.
Because options are levered, each contract is equivalent to holding 100 shares of stock. Short put option positions are typically cash secured. The put option writer must have enough money available in his or her account to cover the cost of 100 shares if assigned.
A short put is sold when the seller believes the price of the underlying asset will be above the strike price on or before the expiration date and/or implied volatility will decrease. The closer the strike price is to the underlying’s price, the more credit will be received.
Selling a put option can be used to enter a long position if the investor wishes to buy the underlying stock. Because selling options collects a premium, initiating a long position with a short put reduces the cost basis if the put is ultimately assigned to the option seller.
A short put trade is initiated when a seller writes a put option contract. Put options are listed in an options chain and provide relevant information regarding each option for every strike price and expiration available, including the bid and ask price. The amount received at trade entry is called the premium. Market participants consider multiple factors to assess the option’s premium value, including the strike price relative to the stock price, time until expiration, and volatility.
The payoff diagram for a short put represents the risk involved with selling naked options. Profit potential is limited to the amount of credit received. However, the risk is unlimited until the stock reaches $0 if the underlying asset experiences a price decline. Selling a short put collects a credit, and the amount received is the most an investor can make on the trade.
For example, if a short put option with a strike price of $100 is sold for $5.00 of credit, the maximum profit potential is limited to $500, and the maximum loss is undefined below the break-even point until the stock reaches $0. The strike price minus the premium collected equals the break-even price of $95. Anything below the break-even price will result in a loss that could be substantial.
To enter a short put position, a sell-to-open (STO) order is sent to the broker. The order is either filled at the asking price (market order) or at a specific price an investor is willing to collect (limit order). Once a put option is sold, cash is credited to the trading account.
Because selling put options has considerable downside risk, the broker will typically require the account to have enough money if the option is assigned. For example, if one put option is sold at the $100 strike price, the broker may require at least $10,000 of available funds in the account.
There are multiple ways to exit a short put position. Anytime before expiration, a buy-to-close (BTC) order can be entered, and the contract will be purchased at the market or limit price. The premium paid will be debited from the account. If the contract is purchased for more premium than initially collected, a loss is realized. If the contract is purchased for less premium than initially collected, a profit is realized.
The buyer of the long put contract can choose to exercise the option at any time, and the seller is obligated to buy 100 shares at the strike price. If the short put option is in-the-money at expiration, the option will automatically be assigned to the option seller. If the stock price is above the strike price at expiration, the option will expire worthless, and the seller will keep the entire premium initially collected.
Time remaining until expiration and implied volatility make up an option’s extrinsic value and impact the premium price. Short put options contracts with more time until expiration will have higher prices because there is more time for the underlying asset to experience price movement. As time until expiration decreases, the price of the put option goes down. Time decay, or Theta, works in favor of put options sellers because the contract’s time value will decline as expiration approaches.
Implied volatility reflects the possibility of future price movements. Higher implied volatility results in a higher price of short put options because there is an expectation the price will move more in the future. As implied volatility decreases, the put option contract will lose value and allow the seller to purchase the contract back for less money. Put options sellers want to sell options when the expectation is implied volatility will be lower on or before expiration.
Short put options positions can be managed during a trade. Short put positions where the underlying security’s price moves away from the short put strike price can be adjusted to extend the time duration of the trade or converted to a risk-defined credit position to minimize loss. The ability to roll options positions into the future allows the trade more time to become profitable and may potentially bring in more credit.
If the stock price falls below the short put strike price, a put option can be purchased at a lower strike price to convert the position into a bull put credit spread. This will decrease the maximum loss on the trade.
For example, if a $100 put option is sold, a $90 put option can be purchased. This will lower the overall credit received on the original position. However, doing so will limit the maximum loss on the position to the width of the spread minus the credit received.
If an investor wants to extend the trade, the short put option can be rolled out to future expiration dates. Rolling out the option requires buying-to-close (BTC) the currently held position and selling-to-open (STO) an option with the same strike price at a future date. Doing so should result in receiving credit and will extend the break-even price and increase the profit potential relative to the original position. The risk will be reduced by the amount of the credit received but is still undefined.
To hedge a short put, an investor may sell a call with the same strike price and expiration date, thereby creating a short straddle. This will add additional credit and extend the break-even price above and below the centered strike price of the short straddle equal to the amount of premium collected. While this reduces cost basis, the risk is still undefined and potentially substantial.
Another strategy to hedge a short put is to buy a put below the original strike price to create a bull put credit spread. Adding the long put will cost money but reduces the maximum loss to the width of the spread minus total credit received. The maximum profit potential is still limited to total credit received and will only be realized if the underlying price stays above the short put strike price.
A synthetic short put combines long stock with a short call option at the strike price of the original long stock position. This creates a synthetic short put because the payoff diagram is similar to a single short put option. As with a naked short put, the expectation is price will rise before expiration.
Selling the call will collect a premium, but the risk beyond the premium received is still unlimited if the stock continues to fall. The maximum profit potential is limited to the premium collected for the short call. If the stock closes above the strike price at expiration, the long stock will be covered when the short call is exercised, and the shares will cancel out.