What is a short put option?

A short put is simply the sale of a regular put option. When a put option is sold, the seller is said to short the put option. When a trader is shorting a put option, they sell the rights to short the options underlying stock at a later date – anytime before the expiration of the option – at the same price (known as the strike price) and volume of shares specified in the contract itself.

The entire goal of the short put is to earn from the options premium being received without the option ever being exercised. The options seller can however incur a loss from a short put option if the buyer decides to exercise the option. In this case, the seller is required to purchase the underlying stocks at the strike price, which would incur a loss for the seller. One of the primary risks associated with short puts is the price of the stock or underlying asset falling below the strike price.

Short put options can be an unfavourable option for those who are inexperienced in dealing with the options market as the profit derived from a short put is limited to the amount of premium received on the sale of the same. However, the risk associated with the short put of an option can be much greater. The writer of the put is required to buy the underlying assets at the strike price, if the asset price falls below the strike price, the writer could face a significant loss.

For example, let’s say the strike price is Rs 100 and, the price of the underlying falls to Rs 90. The put writer will face a loss of 10 rs per share (less the amount of premium received when shorting the put). At this point they have a couple of options to look out for – they can either close out the option trade (buy an option to offset the short) to realize the loss, or they can let the option expire which will cause the option to be exercised and the put owner will own the underlying asset at Rs 100.

Example of a short put

Suppose you’re a bullish investor trading on the stock of ABC Corp – a hypothetical stock. Now, ABC Corp is currently trading at 1000 rs per share. But you, having a bullish mindset and some sort of insight into the matter perhaps, believe that this share will rise to 1100 for a few months. You could generally function as a regular investor and just buy a particular number of the shares expecting the rise. But, to buy 100 shares, you would then require Rs. 1,00,000, an amount you may not have liquidly available. In such a case, a put option will generate income for you immediately but it could lead to significant potential losses in the future.

Suppose you write a put option of Rs. 1025 expiring in 3 months at Rs. 200; your maximum gain is now limited to Rs. 20,000 (Rs. 200 x 100 shares) which will occur if the price closes at or higher than the strike price of Rs. 1025 at the time of expiration. However, your maximum loss can be much higher – Rs. 82500 or (1025 – 200 rs) x 100 shares. This maximum loss is only likely to occur if the value of your underlying falls to an absolute zero and the put writer is assigned to buy the shares at Rs. 1025 per share. The maximum loss is partially offset by the premium received from selling the option.

This is why adequate knowledge, research and technical analysis, as well as fundamental analysis skills, may be required when placing a short put or trading in options. You have limited potential upside with a much larger potential downside in the case of your purchased option falling below the strike price.

Short put mechanics

Initiating an options trade to open a position by selling a put is different from buying an option and then selling it. The sell order is used to close the position or lock in the trader’s profit or loss whereas, in the former option, the sell itself or the ‘writing’ is initiating or opening the put.

A trader that is initiating a short put inherently believes that the asset’s price will remain above the strike price. If the price of the underlying stays above the strike price then the option will expire worthlessly and the writer gets to enjoy the premium. But, if the price of the underlying falls below the strike price, the writer may face potential losses.

Naked and covered short puts

The strategy for a naked put assumes that the value of the underlying or the asset will generally fluctuate but lead to a rise over the next month or so. The trader executes the strategy by selling a put option without holding any corresponding short position in their account. If a buyer wishes to exercise their right to the option, the initiator has no position with which to fill the terms of the options contract. Hence, the sold option is uncovered or naked.

The naked put option is not consequential when the price of the underlying goes up. In such a situation, the value of the option goes to zero and the initiator gets to enjoy the premium that was received upon shorting the put. A naked put strategy is inherently risky because of the limited upside profit potential and, theoretically, a significant downside loss potential. This is why traders only choose to carry out a naked put strategy with stocks they consider to be immensely favourable to them.

Conclusion

The entire goal of the short put writer is to earn from the options premium being received without the option ever being exercised. There may be limited potential upside with a much larger potential downside in the case of writing falling below the strike price. Now that you have the theoretical knowledge to read and make financial decisions based on the short put and short-selling, it’s time for you to put that knowledge to practical use! open Demat Account with us today to excel your trading journey with expert advice, algo-trading research and more such helpful techniques to trading.

Frequently Asked Questions

1. What is the maximum gain on a short put?

The maximum gain on a short put is limited to the amount of premium that the seller of the short put receives. However, the potential losses may be much higher.

2. How do you cover a short put option?

To cover a short put option an investor keeps a short position in the underlying security for the put option, the underlying security and the puts are respectively shorted and sold in equal quantities.

3. How much can you lose on a short put?

Let’s consider you’re interested in a share trading at Rs. 1000. You write a put option of Rs. 1025 expiring in 3 months at Rs. 200. Hence, your maximum gain is now limited to Rs. 20,000 (Rs. 200 x 100 shares) which will occur if the price closes at or higher than the strike price of Rs. 1025 at the time of expiration. However, your maximum loss can be much higher, Rs. 82500 or (1025 – 200 rs) x 100 shares. This maximum loss is only likely to occur if the value of your underlying falls to an absolute zero and the put writer is assigned to buy the shares at Rs. 1025 per share