Introduction To Short Put Option Strategy
The short put option strategy involves the writing of puts, naked, when the options trader forecasts that the price of an underlying security will be stagnant or rise, such that on expiration date, the price of the underlying security will be above the strike price of the put, causing it to expire worthless. When the option expires worthless, the trader gets to keep the credit. The other motivation to short a put is to eventually own the underlying security.
Net Debit/credit
Shorting a put results in a net credit to the trader’s account.
Margin requirements
Since shorting a put a riskier than owning a put, margin requirements will be relatively more stringent.
Steps
Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook : Stagnant or rising
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5 : Understand Your Profit Zones
Step 6 : Limited Loss
Step 7 : Calculate Loss
Step 8 : Calculation of maximum profit
Step 9 : Calculate Risk & Reward Ratio
Step 10 : Set Up Trade
Step 11 : Record Trade In Diary
Step 12 : Example
Step 1 : Perform economic, fundamental and technical analysis
At step 1, the options trader must perform economic, fundamental and technical analysis. Doing so will give the trader the conviction to enter the trade. Suggested chart patterns that the trader should look out for are:
Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis
Step 2 :Outlook : Stagnant or rising
After step 1, the trader should be fairly convinced of the probability that the price of the underlying security will stay stagnant or rise.
Step 3 :Study the option chain
The trader should study the option chain next and select the put option to be shorted. The question is whether the trader should select an ITM or OTM put option to be shorted. This depends on the trader’s forecast of the underlying security’s price. If the price of the underlying security is expected to move above and beyond the strike price of the underlying security with a high probability, then, the trader may consider using an ITM put option to be shorted. While shorting ITM options results in a higher net credit received than shorting OTM put options, there is also a higher risk of assignment for shorting ITM options.
Read : Learn to read and understand options chain
Step 4 : Breakeven Analysis
Exercise price or Strike price – net credit
There is only 1 breakeven point of a short put.
Step 5: Understand Your Profit Zones
The left side of the breakeven point is where the short put trade is in a loss.
Step 6 : Limited Loss
The potential loss is limited in a short put. This occurs when the price of the underlying security goes to 0.
Step 7 : Calculate Loss
The maximum loss can be calculated as :
Exercise price – net credit
Step 8 : Calculation of maximum profit
The profit is limited to the net credit received when the trade was first executed.
Step 9 : Calculate Risk & Reward Ratio
The next thing to do is to calculated the risk and reward ratio. Does the trade make sense on a risk to reward basis?
Read more : Understanding Risk/Reward Ratio For Option Traders
Step 10 : Set Up Trade
If the trade’s risk/reward ratio is acceptable to the trader, the trader should set the trade up. He can do this by shorting put options. This is also known as writing naked puts.
Step 11 : Record Trade In Diary
After the trade has been exited, it should be recorded in a trading diary for reference and reflection. One should always learn from mistakes.
Step 12 : Example
John shorts a December 40 put on AAA Corp at a price of $2, receiving a credit of $200. When the price of the underlying security, AAA Corp trades at $45 on expiry, the put options expire worthless. John thus gets to keep the net credit.
Read also : Synthetic short put to profit from bullish or stagnating conditions