When you short a put option, you receive an upfront premium from the buyer. You also could be obligated to buy shares of the underlying stock.
Shorting Put Options: Basics of Shorting Put Options
You've likely encountered a situation where you find a stock you would like to invest in but a recent run up in price makes you question whether it is overvalued. You tell yourself that you'd buy it if the price drops a percent or two. Maybe the stock does not come back to your target and you miss out on an opportunity.
This may be a situation in which you could consider selling short or writing a put option rather than placing a stock limit order. The short put may allow you to get in at a lower cost basis, while providing some profit if the stock price continues to rise. Here's how it works:
When you short a put, you take on the obligation to buy shares at the put option strike price.
This will occur if the stock is below the put strike price at the expiration of the contract, and it fits with a goal of buying the stock if it were to drop to a target price. If the stock does not fall below the put strike price of the contract, then contract expires as worthless, and the put seller keeps the premium.
Let's look at a hypothetical example. Company XYZ just came out with the latest and greatest widget. The price of the stock soars to $100 after the announcement. You want to buy the stock but feel that the price has gone too high because of the hype around the widget. You'd be willing to buy the stock for $95.
The following are quotes for XYZ put options.
The put contract obligates the put seller to buy the shares of stock at the strike price of the put. On the surface you'd think you should look to the $95 strike price put. However, you need to take into consideration the $2 per share premium received when selling the put. The table shows that selling the $97 strike put for $2 gives us an effective buying price on the stock of $95.
Let's look at the profit/loss diagram to graphically parallel selling the $97 strike put compared to buying the stock. The blue line represents the profit or loss of a stock-only position, and assumes you buy the stock at $100 per share. The red line represents the profit or loss of a short put position.
If the stock is below $97 at the contract expiration, you will be obligated to buy shares of stock from the put owner for the $97 contract strike price. The effective purchase price on the shares is $95 since you received a $2 payment up front. At $95 per share, you have the same downside risk of stock ownership. This is evident by the parallel red and blue lines.
If the stock price is above $97 at time of the contract expiration, the owner of the contract would not exercise the contract since he would able to sell the stock at a higher price in the open market. The contract would expire worthless. This leaves the put seller with a $2 per share profit from the premium received. Of course, the seller would not own the stock, and would not profit from the increase in the price of the stock.
This illustration is hypothetical and does not reflect actual investment results or guarantee future results.
How to Do it
You are able to sell short or write a put if your account is approved for option trading.
In a cash account, you will be required to hold enough cash to buy the underlying security. The typical option contract represents 100 shares of stock, so in the example above, you have been required to hold $9,700 ($97 x 100). This cash cannot be used for other activities until the short put position is closed.
In a margin account, you can short a put with an uncovered or “naked” margin requirement. This requirement is typically much less than the cash-secured requirement, but you have the same obligation to buy shares for $97 per share. Margin leverage increases purchasing power and possible rate of return, but it can also expose you to higher losses.
Additionally, the margin requirement will increase if the stock price drops. This could lead to a margin requirement greater than the equity in your account (margin call). Such situations will require you to deposit more money, close the position or force the sale of other securities in your account. Trading naked options has a higher level of risk and requires a greater level of expertise and attention.
Options contracts are affected in ways that might be unfamiliar to stock traders. It is important to keep these things in mind when trading short puts.
- You are not required to hold the put until the expiration of the contract. You are able to buy to close the short put position at any point prior to the contract expiration or exercise. A buy-to-close trade would require you to pay a premium to close your obligation (just as you had received a premium when you sold to open the put). The profit or loss on the trade will be the difference between the premium you received when you sold the put to open, and the premium you paid when you bought it to close, less commissions and fees.
- The put is not assigned to you immediately if the stock drops below the put strike price. In other words, you won't necessarily have to immediately buy the stock if the market price falls below the strike price. Contracts typically are exercised by long put holders at or near the expiration date. This is an important difference from a limit buy order for the stock. The stock could drop below the strike price and then rally above it prior to the contract's expiration and the contract will not be assigned. This would leave you without a long stock position. In that case, you will need to buy to close the put position first and then buy the underlying stock if you still wish to buy the underlying security
- The price of the put is affected by factors other than just the underlying stock price, including time until expiration and expected volatility. Option prices tend to decrease if expected volatility decreases. The option price will also tend to decrease as the expiration approaches. This affect is called time decay and the price erosion typically accelerates as expiration nears.
Options involve risk and are not suitable for all investors. Detailed information on our policies and the risks associated with options can be found in Scottrade's Options Application and Agreement, Brokerage Account Agreement, and by downloading the Characteristics and Risks of Standardized Options booklet. You can also order a copy of the booklet by phone at 1-888-OPTIONS or obtain a copy at a Scottrade branch office. Market volatility, volume, and system availability may impact account access and trade execution. Consult with your tax advisor for information on how taxes may affect the outcome of these strategies. Keep in mind profit will be reduced or loss worsened, as applicable, by the deduction of commissions and fees.
There are special risks associated with uncovered option writing that may expose investors to significant losses. There¬fore, this type of strategy may not be suitable for all customers approved for options transactions. Clients approved for uncovered put writing must acknowledge having received and read the Special Statement for Uncovered Options Writers concerning the risks of this type of trading.
Margin trading involves interest charges and risks, including the potential to lose more than deposited or the need to deposit additional collateral in a falling market. Scottrade's margin agreement is available at scottrade.com, or through a Scottrade branch office, and contains the Margin Disclosure Statement and information on our lending policies, interest charges, and the risks associated with margin accounts.
The analytical tools and strategies described in this article are for information purposes only and their use does not guarantee a profit. None of the information provided should be considered a recommendation or endorsement of any specific investment, tool or strategy. The choice to engage in a specific investment, tool or strategy should be based solely on your research and evaluation of risks involved, your financial circumstances and investment objectives. Securities are subject to market fluctuation and may lose value. Market volatility, volume, and system availability may impact account access and trade execution.
Examples used will not show the deduction, or inclusion, of commissions and other costs that may significantly affect the performance of the given strategy. They do not take into consideration tax consequences or fees with minimal impact on a given strategy. An investor should understand the impact of transaction costs, margin fees and requirements, and tax considerations before entering into any options strategy. Consult your tax, or legal, advisor for questions concerning your personal tax or financial situation