What Is a Short Put?
Let me explain what a short put is. It's when you, as a trader, open an options trade by selling or writing a put option. The buyer of that put is long on it, while you, the writer, are short.
As the writer, you receive the premium, which is the cost of the option, and your profit on this trade is limited to that premium amount.
Key Takeaways
You need to know that a short put happens when you sell or write a put option on a security. The core idea is to profit from a rise in the stock's price by collecting the premium from the sale. However, if the price declines, you'll face losses as the option writer.
Basics of the Short Put
A short put is also known as an uncovered put or a naked put. If you write this put option, you're obligated to buy shares of the underlying stock if the buyer exercises it.
You could also end up with a big loss even before exercise or expiration if the underlying price drops below the strike price of your short put.
Short Put Mechanics
You create a short put by opening a trade through selling a put. For this, you receive a premium as the writer, and your profit is capped at that premium.
Remember, starting by selling a put to open a position differs from buying an option and then selling it to close. The latter locks in your profit or loss, while the former opens your short put position.
If you initiate a short put, you probably believe the underlying price will remain above the strike price. If it does, the option expires worthless, and you keep the premium. But if it falls below, you face potential losses.
Some traders use this to acquire the underlying security. For instance, if you want to buy a stock at $25 but it's at $27, sell a put with a $25 strike. If it drops below $25, you buy at $25, which you wanted anyway. Plus, if you got a $1 premium, your effective cost is $24. If it doesn't drop, you keep the $1.
Risks of Selling Puts
Your profit on a short put is limited to the premium, but the risk can be huge. As the writer, you're required to buy the underlying at the strike if exercised. If the price falls below, you could take a significant loss.
Take an example: if the strike is $25 and the underlying drops to $20, you're looking at a $5 per share loss, minus the premium. You could close the trade by buying to offset, or let it expire and get assigned, owning at $25.
If exercised, you'll need cash to buy the shares—for every contract, that's $2,500 at $25 per share times 100.
Short Put Example
Suppose you're bullish on hypothetical stock XYZ at $30 per share, expecting it to hit $40 in months. Buying 100 shares would cost $3,000, but writing a put generates income now, though with loss risk if it falls.
You write one put with a $32.50 strike, expiring in three months, for $5.50 premium. Max gain is $550 if it closes at $32.50 or higher. Max loss is $2,700 if it goes to zero and you're assigned at $32.50, offset somewhat by the premium.
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