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A short put option is a popular strategy among option traders that allows them to potentially buy shares of a company at a discount.
Short puts are a bullish strategy, but less bullish than buying stocks directly.
By selling puts, the trader can collect a premium while waiting to potentially buy the stock at a lower price.
If you are looking to trade the short put options strategy, you have come to the right place as this article will walk you through everything you need to know.
A short put option is a strategy in which the trader sells or “writes” a put option in order to receive the option premium.
To receive the premium, the put seller has one Obligation to buy the shares at the exercise price, if requested.
The maximum profit from trading is limited to the premium received, which is why the strategy is less optimistic than direct stock ownership (stock buyers have unlimited uptrend).
Downside losses are limited but are similar to owning shares.
If the stock price rises to $ 0, the put seller will lose the strike price x 100 minus the premium received.
Let’s work through a quick example using Coca Cola (KO) stocks:
Trade date: February 5, 2021
Base price: 49.75
Trade details:
Sell 1 KO May 21, 47.50 Put @ 1.70
Net credit: $ 170
Venture Capital: $ 4,580
Here we can see that the maximum profit is equal to the received bonus of $ 170.
The breakeven price corresponds to the exercise price (47.50) minus the premium received (1.70), which corresponds to 45.80.
If we multiply the 45.80 by 100, we have the venture capital ($ 4,580), which is also the maximum possible loss.
In terms of the return profile, we take the premium ($ 170) divided by the venture capital ($ 4,580), which gives us a potential return of 3.71% in just over 3 months.
We can convert this to an annualized return by taking the days in a year (365) divided by the days in trading (106) and multiplying that by the return (3.71%).
This gives a potential annualized return of 12.90%.
I have a small Excel-based calculator that I can use to do these calculations quickly and easily. You can download here.
As a bullish strategy, this trade should only be placed on stocks of the investor ready to buy.
There are a few other points to keep in mind.
Implied volatility is an important factor in the value of options.
A higher implied volatility corresponds to higher option premiums, which corresponds to higher returns.
As we know, higher returns are also associated with higher risks.
In our example above, KO was used, a stock with low volatility.
If we looked at a similar setup for NIO, the annualized return would be closer to 61%. But it’s a much riskier stock.
The best time to short put trades is after the stock has fallen sharply, which means that implied volatility is increased and the stocks trade at a discount.
Occasionally I do short put trades in high volatility stocks, but I prefer stable blue chip stocks.
Any stock in the Dow Jones Industrial Average is fair, but some have much higher value than others.
For example, a short put trade with United Health (UNH) would require around $ 32,000 in capital if the put were allocated, while KO would only need $ 4,580.
ETFs are also great for this strategy as there is no stock-specific risk. No quarterly earnings reports to worry about.
Multiple option expiration periods are available for each share, from weekly options to longer-term LEAP options.
So what process should traders look for in order to sell?
Short-term options produce the highest annualized return but offer the lowest margin of error.
Longer-term trades produce a lot of premium (and therefore a larger drop in breakeven price), but since the time decay is slower, the annualized return is lower.
Below is a comparison of a 4-day, 39-day, and 253-day short put trade using Apple Stock (AAPL).
You can see above that the very short term puts produce a huge annualized return of 101.08% but only cause the breakeven price to drop by 1.80%.
The longest term trade still offers a pretty good annualized return of 26.47%, but also an 18.92% drop in breakeven price.
The most important thing is to find a style that suits you.
If you are an active trader, the short term trades may be your style. However, if you prefer a more passive approach, the longer-term style may be more suitable.
For advanced traders, there is one more step that can be taken after a short put trade has been assigned.
Once the put is assigned, the trader owns 100 shares of the stock.
You can still hold that and collect the dividends, but what about options to generate more income?
This is certainly possible, and many traders will do it by selling covered calls, effectively doubling the premium the trader receives.
They received a premium for selling the first put and then a second option premium for selling a covered call.
If the trader has a very bullish outlook, he should sell the call well out of the money.
If they have a more neutral outlook, the call should be sold close to the money.
Short put options are an option strategy that is great for generating income from stocks that the trader is willing to own.
It is a neutral to slightly bullish strategy.
The ideal scenario is for the stock to stay flat or rise slightly so that the trader can keep the option premium without having to buy the stock.
If the stock falls below the short put strike, the trader may be assigned to the trade and forced to acquire 100 shares of the stock.
After taking over the share, the trader can sell covered calls to generate additional option premiums.
Trade safe!
Gav.
Disclaimer: The above information applies to For educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are unfamiliar with exchange-traded options. All readers interested in this strategy should do their own research and seek advice from a licensed financial advisor.
