What it means
A put option gives its buyer the right, but not the obligation, to sell 100 shares at a fixed price called the strike. When you sell that option, you are on the other side.
If the buyer exercises the right, you must buy the shares at the strike, whatever the market price is at that time. For taking on that obligation, you receive a premium, which is the price of the option, straight away.
If the stock finishes above the strike when the option expires, the buyer will not exercise and you keep the whole premium. That is the best case, and it is also the most you can earn.
If the stock falls below the strike, you are in trouble in proportion to the fall. You end up owning shares worth less than you paid, offset only by the premium you collected.
The worst case is the stock falling to zero, so the loss is large though not unlimited. Many investors use a short put deliberately as a way to buy a stock they like at a discount.
They pick a strike below today's price, collect the premium, and are happy to own the shares if the price drops there. This approach is often done with cash set aside to cover the purchase, which is called a cash-secured put.
Brokers require margin, meaning cash or collateral held as security, when you sell a put. Margin requirements grow if the stock falls, so a short put can trigger a demand for more funds at an awkward time.
Anyone using it should keep spare liquidity.
In practice
Real-world examples.
Example
A retired engineer owns $200,000 in cash and wants to buy shares in a large utility company, currently priced at $60. She sells a put with a $55 strike and collects $1.50 per share. If the shares fall to $55, she buys them at an effective cost of $53.50, which is below the original price.
Example
A portfolio manager at a family office sells puts on an index fund each month to earn premium income. The index stays above the strike in most months and the office keeps the premium. In a sharp market fall, it takes a loss and keeps cash available to avoid forced selling.
Example
A technology startup founder with a large holding of her own listed company's shares wants to add more at a lower price. Her advisor warns that selling puts on her own company stacks risk onto risk. She decides to sell puts on a broad technology index instead.
Formula
Calculation
Break-even price = strike price - premium received per share
Maximum profit = premium received x 100 shares per contract
Maximum loss = (strike price - premium received) x 100 shares per contract
Suppose an investor sells one put contract on a stock trading at $42, with a $40 strike, receiving a $2.00 premium per share. The premium collected is 2.00 x 100 = $200, which is also the maximum profit. The break-even price is 40 - 2 = $38. If the stock falls to $30, the investor must buy at $40, a loss of (40 - 30) x 100 = $1,000 on the shares, less the $200 premium, giving a net loss of $800. The maximum loss, if the stock goes to zero, is (40 - 2) x 100 = $3,800.Case study
Seen in the real world.
Lanternfield Advisory is an illustrative, fictional wealth management firm. One of its clients wanted to buy 1,000 shares of a manufacturing company trading at $80, but thought the price looked a little high.
The adviser suggested selling ten put contracts with a $75 strike at a premium of $3.00 per share, which brought in $3,000 and set aside $75,000 of cash as cover. If the shares stayed above $75, the client would keep the premium as income.
The shares dipped to $72 at expiry, so the client bought them at an effective price of $72 per share, which is the $75 strike minus the $3 premium. The client owned the stock at $8 less than the $80 price first seen. The illustrative lesson is that a short put works well when you want to own the shares anyway, and badly when you only want the income.
Watch out
Common mistakes.
- Selling puts for the premium alone, without being willing to own the stock at the strike price.
- Ignoring margin, when a falling stock can trigger a call for additional funds.
- Believing the risk is small because the maximum profit is small, when the maximum loss is many times larger than the premium.
Questions
People also ask.
What happens if the stock stays above the strike?
The option expires worthless, the buyer does not exercise, and you keep the full premium as profit.
Can I close a short put before expiry?
Yes, you can buy back the same option at its current price, which locks in a profit or loss without taking delivery of the shares.
Is a short put the same as a covered put?
No, a short put means selling a put option, while a covered put refers to a related strategy that also involves a short position in the underlying stock.
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