Short Put Option Strategy: Key features and set-up

Overview

Selling a naked put option is like betting your friend won’t mess up a simple task—it’s risky but can pay off.

Each short put contract is like holding 100 shares. It’s called “naked” because there’s no protection if things go south. Usually, you need to have enough cash in your account to cover the cost if you end up having to buy the stock.

What is a Short put?

A short put is an options strategy where you sell a put option, agreeing to buy a stock at a specific price if it drops below that level before expiration. In return, you collect a premium upfront.

This approach works well if you believe the stock will stay above the strike price, as it allows you to earn income while potentially buying the stock at a discount if it declines. 

How to set-up a Short Put?

Start by writing or selling a Put Option contract. The options chain is like a menu with all the strike prices and expiration dates. The money you get from selling the put is called the premium. This depends on the strike price, time until expiration, and how much the market is freaking out.

Payoff Diagram

The short put diagram shows the risk involved with selling naked options. Profit potential is limited to the credit received when the put is sold, while the risk is unlimited until the stock hits ₹0.

For example, if you sell a short put option with a strike price of ₹1000 for ₹50, your maximum profit is ₹50. The maximum loss is unlimited below the break-even point. The break-even price is the strike price minus the premium collected, which is ₹950. If the stock price is below this at expiration, you’ll face a loss.

Entering a Short Put

Place a sell-to-open (STO) order to start. Cash hits your account like a Bollywood hero hitting bad guys. But remember, the broker will make sure you have enough funds to cover the potential purchase of 100 shares. If you sell a ₹100 put, you might need at least ₹10,000 in your account.

Exiting a Short Put

To exit, place a buy-to-close (BTC) order. If you buy it back for less than you sold it, congrats, you’ve made a profit. If not, you’re out of luck. If the buyer exercises the put, you have to buy 100 shares at the strike price.

If the stock price is above the strike price at expiration, the option expires worthless, and you keep the premium-like finding extra fries at the bottom of the bag.

Time Decay Impact on a Short Put

Time decay or theta is your ally here. As expiration gets closer, the option’s value drops, which is good for you. It’s like watching your in-laws visit shorten-pure relief.

Implied Volatility Impact on a Short Put

Higher implied volatility means higher option prices because everyone’s nervous. If volatility drops, the option’s price drops, which is excellent for you. You benefit when the market chills out, like after a cricket match victory.

Adjusting a Short Put

You can manage short put options to minimize risk. One way is to convert a short put into a bull put credit spread.

• Original Setup: You have a single short put option.
• Adjustment: Buy a put option at a lower strike price.
• Benefit: This defines your risk and lowers the profit potential.

Example:

• Initial: Sold a ₹1000 put for ₹50
• Adjustment: Bought a ₹900 put for ₹20.

Calculations:

• Maximum Profit: Credit received from selling the put – Cost of buying the lower strike put = ₹50 – ₹20 = ₹30.
• Maximum Loss: Difference in strike prices – Net credit received = (₹1000 – ₹900) – ₹30 = ₹100 – ₹30 = ₹70.
• Break-even Point: Strike price of the sold put – Net credit received = ₹1000 – ₹30 = ₹970.

So, after the adjustment:

• Max Profit: ₹30
• Max Loss: 70
• Break-even: ₹970

Rolling a Short Put

You can extend the trade by rolling the short put option. This means buying-to-close (BTC) your current position and selling-to-open (STO) a new put option with a later expiration date.

Example:

• Initial: ₹1000 put expiring in March sold for ₹50.
• Adjustment:
  • Bought back ₹1000 put of March before expiry for ₹30 (net gain ₹20).
  • Sold a new ₹1000 put for April for ₹50.

Calculations:

• Net Credit Received: Premium from the new put – Cost of buying back the old put = ₹50 – ₹30 = ₹20.
• Total Credit (Max Profit): Initial credit received + Net credit received = ₹50 + ₹20 = ₹70.
• Break-even Point: Strike price – Total credit = ₹1000 – ₹70 = ₹930.

So, after rolling:

• Total Credit: ₹70
• Break-even: ₹930

Hedging a Short Put

You can hedge a short put by selling a call with the same strike price and expiration date, creating a short straddle.

Example:

• Initial: ₹1000 put sold for ₹50.
• Adjustment: Sold a ₹1000 call for ₹50.

Calculations:

• Total Credit Received: Credit from the put + Credit from the call = ₹50 + ₹50 = ₹100.
• Break-even Points:
  • Upper Break-even: Strike price + Total credit = ₹1000 + ₹100 = ₹1100.
  • Lower Break-even: Strike price – Total credit = ₹1000 – ₹100 = ₹900.

So, after hedging:

• Total Credit: ₹100
• Break-even Range: ₹900 to ₹1100

Synthetic Short Put

You can create a synthetic short put by combining a long stock position with a short call option at the same strike price.

Example:

Profit potential is limited to the premium collected for the short call.

• Result: Downside risk is limited to the premium received.
• Action: Own ₹1000 worth of stock and sell a ₹1000 call option for ₹50.

Conclusion

The short put strategy is a powerful tool in the arsenal of options traders, offering the potential for income generation in a stable or declining market. By selling call options, traders collect premiums upfront, capitalizing on the expectation that the underlying asset will remain below the strike price or decline.