What is a Short Put in Options Trading?

Short Put (selling or writing a put option): As announced, in this article I am following up on the previous one. The example shows how the skilful use of options can help to make a more favourable entry into a stock investment. In this way, shares “called away” from a short call can also be bought back.

Furthermore, the short put can also be traded as a single strategy with defined risk parameters. At this point I assume that you are familiar with the technical terms used. These are also briefly explained in the first article of the series (The Long Call). There is also a brief explanation of the Greeks.

As with the short call, the trader with a short put is in the position of the still holder. As long as no major changes occur, a profit is made by reducing the time value of the option. If the option is out of the money at the end of the term, the entire premium can be collected on the expiration date. Again, there are several ways to manage the trade. Enjoy reading.

The short put in the option chain

From the meanwhile well known option chain of the broker, the current prices can also be taken for the sale of a put option. For the trade in this example I chose the put on Apple with a base price of 245 dollars. As with the sale of a call option, the prices on the bid or the money side count.

In order to get the best price at a given time, it is recommended to open the sell order with the higher ask price. Then you can gradually lower the limit towards the bid price until the order is executed. Usually the middle between the two prices provides a good benchmark.

Observe and use the spread

How to make the best use of the spread is discussed in the article “The Long Put”. A wide spread indicates a thinner market in the corresponding options. If not enough interested parties demand the contracts, the market makers widen the bid-ask spread to reduce their own risk. Nevertheless, the prices are not set in stone.

The prices displayed represent, so to speak, an offer within the framework of the current relationship between supply and demand. Since this ratio changes with your own order, it is advisable to set a limit. This allows the trader to check whether the market maker does not want to buy at a better price.

The same applies if an option is to be closed before the expiration date. It is irrelevant whether this is profit taking or loss limitation. In both cases you naturally want to get the best possible price.

Beware of unfavourable execution and additional fees

I would also advise against a market order for extremely liquid options. There is always the risk of unfavourable execution or slippage in the event of a spontaneous price movement.

Additional costs may arise if the limit is adjusted step by step until execution. Some brokers charge an extra fee for limit changes. In order to avoid surprises, it is advisable to take a look at the current list of prices and services.

The duty of the stillholder as an opportunity

From the article “The Long Put” we know the right of the buyer to sell the underlying asset at the strike price. This results in the obligation for the writer on the seller’s side to buy the corresponding underlying asset. In the example this would be 100 Apple shares at a price of $245.

For the example, let’s assume that the writer wants to buy 100 Apple shares. On the basis of his current market opinion, he sees the possibility of a correction up to the price range of $245. On the basis of the delta, the chance of this is around 20 percent.

Buying shares cheaper

The possible premium income is $2.58. Accordingly, the trader as seller of the option gets paid the risk with 258 dollars per contract. The amount of the premium is determined by the multiplier, which for stock options is usually 100 shares per option contract.

Check the multiplier

In order to ensure which multiplier is applied to a particular option, this should be verified via the trading platform. Using the example of Interactive Brokers and their Introducing Broker (in my case CapTrader), a right click with the mouse on the corresponding option is sufficient. Then select “Financial Instrument Info” and “> Description” from the context menu.

Full premium in case of early exercise

The description also includes the exercise style of the option. With the American style, early exercise by the buyer is possible at any time. If the option runs into the money, i.e. Apple’s price falls below $245, the risk of exercise by the buyer increases.

The option now has an intrinsic value and the falling price of the underlying asset can lead to the option holder wanting to sell his shares in this way. In this case, we as the seller would be credited the full amount of the premium. This would reduce the purchase price of the shares accordingly.

This is briefly illustrated in a formula:

$245 (base price) minus $2.58 (premium) results in an acquisition price of $242.42
With a multiplier of 100, the trader must have the corresponding amount of $24,242 available on the trading account. The shares will then be booked in the event of exercise. Such a procedure to get shares at a discounted entry is called a “cash secured put”.

Receive a Constant Premium

If the price does not go into the money, the trader has at least earned a premium of $258 on the expiration date. Depending on the price development and market opinion, he can then write another cash secured put. Whoever wants the shares absolutely, can also go closer to the money with the strike price. Here higher premiums lure, but the risk increases in case of a strong downward movement.

The trader would be exposed to the same risk with a direct investment in Apple. With the approach of wanting to own the shares as a long-term investment, the risk must therefore be considered in relation to the personal strategy and the overall portfolio. Certain shares also bring additional income through dividends. In this way, many individual components can be combined to create a continuous stream of income.

If the trader received the shares via a short put, covered calls can be written on them again. In this way, the yield of an investment portfolio can be optimised with regular premium income.

The short put as a single strategy

After weighing up all the advantages and disadvantages of the previous articles in this basic series, the short put is now an instrument that can also be traded very well as an individual strategy.

Here, some of the previous disadvantages are now transformed into advantages:

  • The disadvantageous loss of time value when buying options now works on the seller’s side for the trader
  • Due to the skew, the prices (for stock options) are higher on the put side than on the call side
  • The theoretically possible “unlimited loss” feared by the short call is limited with the short put

The theoretically possible loss on a short put depends on the strike price and the price of the underlying instrument. Since the price of a share should not fall below zero, the downward movement would come to an end there at the latest. In the past, it has been shown that even on the way, there is still the odd breather in the price trend. This would allow an exit with a manageable risk before then.

This time the risk is limited

Nevertheless, I do not calculate too tightly for my own trades. A sudden change in market sentiment can significantly increase the broker’s margin requirement, as well as the price of options. This can result in book losses that you just don’t feel comfortable with, even though the option is still clearly out of the money.

It can happen that you have to close a trade based on the risk parameters. If it turns out in retrospect that the option is still not out of the money by the end of the term, this can be annoying and freezing. Basically, the trader was right. However, in my opinion, the alternative of running into a margin call or the forced liquidation of the trading account would be much worse.

For this reason, I look for underlyings with relatively low prices, usually between 40 and 100 dollars. Here, with increased implied volatility, there are also good option prices and trading opportunities. In addition, the drop to zero is not as great, and the margin requirement and overall risk are manageable.

Basically, the following applies:

  • The further out of the money an option is (or the lower the delta), the more sensitive it is to changes in the price of the underlying asset

Total loss – what does that look like?

Should Apple, contrary to all expectations, be worthless overnight, let’s assume a zero dollar exchange rate. The option with the strike of 245 dollars now has an intrinsic value of 24500 dollars. The time value would probably be just a few cents. Closing the position by buying it back would therefore be uneconomical.

I would hold such a position until the expiration date. Maybe something positive will happen to the company and the loss will be reduced until then. After deducting the premium, the sum is the same as calculated for the cost price of the cash secured put.

The maximum possible loss can therefore also be calculated:

  • Total loss = strike price * multiplier – option price * multiplier
  • Properties of the underlying – Implied volatility

The magnetic average – “Reverse to the Mean”

The lower curve in the chart shows the option implied volatility. It is often abbreviated as Implied Volatility or “IV”. From the course of the values, it can be seen that a kind of channel has emerged in the past period. The upper extreme values have not risen significantly above two percent. Likewise, the lows have not fallen below 1.2 percent. This results in an average value of 1.6 percent.

And it is precisely this 1.6 percent that IV seems to magically keep heading for. With a moderate share price development, this value will remain constant for some time. The expression “Reverse to the Mean” has become established for this frequently observed behaviour. This can be used as a simple trading approach.

Sell Expensive

Since the implied volatility is also an indicator for the pricing of the options, the mean value can be used as a guideline for a sale. It is therefore advisable to open a trade if the IV is above the mean value. Experience shows that the option prices are then higher. Also the chance of sinking IV is higher, which would be more favorable for the trade.

In the example trade the IV is currently below the average. However, the trader’s intention was to get the shares with a cash secured put. Furthermore, the premium for the trade is still acceptable. Basically there are two different strategies. The Cash Secured Put is a supplement to an existing investment portfolio. Short puts as an individual strategy, on the other hand, are more suitable for short- to medium-term trading.

The profit and loss profile

As already with the other options, the excel-based P&L profile analysis software from Optionsuniversum is once again providing the best services here. You will find extensive information on the website.

The chart shows the chances and risks of this trade. Assuming that the basic parameters of the option remain the same, there is a safety buffer until the expiration date. The break-even can be calculated using the formula mentioned above and would correspond to the strike price in case of early exercise (strike minus premium). In the example 245 $ strike minus 2.47 $ premium equals 242.53 $ break-even at expiration.

At the same time, the lines up to the expiration date warn of a possible price change in case of unfavorable price changes. If Apple would reach the strike price in the given environment (Greeks and IV do not change much), the position would be about $600 in the red.

The short put forgives even slightly falling prices in a moderate market. This trade can be used to make money in three cases:

  • when the price of the underlying asset rises.
  • or the price of the underlying asset moves sideways
  • and even if the price of the underlying asset falls slightly, ideally the strike should not start

Observation is required

As with falling prices, the Greeks and IV usually change to the disadvantage of the still holder, the development of the trade should be checked at least once a day. It has proven to be a good idea to intervene at the latest when a loss is incurred in the amount of double the premium. For this purpose I use the original idea of the trade and the current situation in the chart.

Should the original idea prove to be invalid, the trade will be closed. If the chart still looks favorable, the option can also be held or managed.

Trade Management – The Roll

The options trader refers to a change in the original position as a roll. Since the existing contract cannot be adjusted in the key data, this means closing the current position and opening a new one.

This is usually done to limit the loss of the current position. The realized loss is to be reduced or offset by premium income from the new contract. The new position is based on the available strikes and premiums. It is also advisable to extend the term of the contract.

Key data for rolling

The Delta is a good point of reference. If the first position was opened with a delta of, for example, 20, I also target the new position in this area. The original strike changes in this respect as well. Thus the new position has air again, if the course continues to fall.

Experience has shown that the premiums are not sufficient to cover the loss in the previous term. Then there is the possibility of opening two new contracts for each contract concluded. Alternatively, a longer term can be chosen.

Paying attention to risk

At this point I would like to advise caution. Too great is the temptation to increase the number of contracts further or to move closer to the price with the strike. Belief in the end of the downward movement is a temptation. It is only too human to want to compensate for the loss.

Based on the option chain and the free margin still available in case of problems, trades can be managed infinitely if necessary. Realistically, however, the goal is rather to limit the loss. To achieve this, the premium income from the new position should almost cover the loss of the closed position, or at least significantly reduce it.

Roll or not?

Soberly considered, it is a matter of shifting an acute problem into the future or further away from the current price. When the price of a share has cracked, there is always a background to this. The valuation of the company by market participants has changed. It would also make sense to examine the share price behaviour in relation to the overall market.

If important supports in the chart are broken for a long time, the trade is better to close. The classic combination of the moving averages 20/50/200 provides first indications in this regard. I then draw the last local low and one or two trend lines from rising lows.

In addition, the rolling process generates fees for additional closing and opening of the contracts. Unfortunately there is no general rule at this point. I personally have used low risk positions to try rolling in practice. Observing the option prices in critical market phases has also helped me to better estimate the selection of new positions to be opened.

My conclusion on rolling

In the toolbox of option strategies, rolling is another tool. Used correctly, even unfavorable trades can still be corrected. On the flip side, however, the potential to carry over losses is also increased. As is so often the case in stock market trading, the multitude of possibilities and different perspectives do not offer a universal “right or wrong” solution.

It is essential, however, to back up fundamental mechanisms with your own experience. This will help to increase the security in dealing with the market and its instruments. This leads to long-term success. It is essential to realize that losses always occur in every strategy.

Strict management of losses prevents individual trades from completely wiping out the account. The right position size is an important factor in protecting trading capital even in the event of unfavourable developments. Likewise, the number of total positions should remain within the range, or be mutually supportive.

For example, short puts can be supplemented with long puts on a deeper strike. The losses are then stopped at this price level at the latest. This strategy offers material for my own article, which I would like to present in an extension of the topic “Options Trading”.

The conclusion on the short put

In my opinion, the short put is the most versatile of the options presented. It can be traded as a single position as well as a supplement in an investment portfolio. Further possibilities are offered in the futures area, which I have not yet dealt with for a simplified introduction.

For first steps and experience in trading with options, US stocks with prices between 20 and 40 dollars are suitable as underlyings. This way the risk remains manageable and the behaviour of the option prices in different market phases can be experienced (and survived).

The combination of the individual options offers potential to implement the most diverse trading ideas with relatively low margin. In the next step I would like to discuss the credit spreads, which offer premium income with a defined risk of loss. I would be pleased if you stay with this and delve deeper into the topic.

Read my other articles about options:

Leave a Reply

Your email address will not be published. Required fields are marked *