This chapter covers the fundamentals of short put options contracts. To get comfortable with the language used when discussing options, watch this video:

When an investor goes short a put, they are bullish on the underlying security’s market price. Selling a put creates an obligation: if the option is assigned (exercised), the investor must buy the stock at the strike price.

• If the stock’s market price falls below the put’s strike price (think “put down”), the put is in the money. The holder may exercise, and the writer must buy at the strike price.
• If the market price rises above the strike price, the put is out of the money. The holder won’t exercise, and the writer keeps the premium as profit.

Definitions

Bullish

Expectation of rising values

Bearish

Expectation of falling values

Let’s work through a few examples to understand short puts better:

Short 1 ABC Sep 75 put @ $6

This contract obligates the writer to buy ABC stock at $75 per share if assigned. The writer received $600 for selling the option ($6 premium x 100 shares). The option expires on the third Friday in September.

The investor is betting ABC stock’s market price stays at or above $75 through expiration. If the market price falls below $75, the holder may exercise the option, which can create losses for the writer.

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Math-based options questions should be expected on the exam. Typically, they ask about potential gains, losses, and breakeven values. Let’s go through each.

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An investor goes short 1 ABC Sep 75 put @ $6. The market price falls to $0. What is the gain or loss?

Can you figure it out?

The maximum loss for a short put can be found using this formula:

$\text{Short put maximum loss}=\text{strike price}-\text{premium}$

The strike price of $75 minus the premium of $6 gives a maximum loss of $69 per share (or $6,900 overall).

In the short call chapter, we learned an option is “naked” when it’s sold without a hedge (protection). The same idea applies to a short put.

A short put is risky because assignment can force the investor to buy shares at the higher strike price when the market value is lower. In the worst case, the investor buys worthless shares at the strike price.

In the next chapter, you’ll learn how investors protect themselves from risk on short options. For now, here is a quick list of investments that would cover a short put:

• Short shares
• Long put
• Cash (equal to the maximum loss)

The risk of a short put comes from being forced to buy shares at the strike price and then potentially having to sell them at a lower market price (or not being able to sell them at all if they’re worthless).

• If the investor is short the shares, the sale already occurred. When the put is assigned, the investor effectively buys back the shares at the strike price, closing the short position. The investor doesn’t have to worry about selling the shares later at a lower price because the sale happened when the stock was sold short.
• If the investor owns a put (in addition to the short put), they keep the right to sell the shares purchased at assignment at the long put’s strike price. Even if the market price drops sharply, they can exercise the long put and sell at that higher strike price.
• While cash doesn’t prevent losses, holding cash equal to the maximum loss technically “covers” the put. The investor has enough money set aside to meet the obligation if assigned. Remember: cash can’t cover a short call because a short call has unlimited risk.

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Let’s look at an example that’s more likely to occur:

An investor goes short 1 ABC Sep 75 put @ $6. The market price falls to $60. What is the gain or loss?

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Investors who sell puts don’t always lose money. Even if ABC’s market price falls below $75, the writer won’t have an overall loss unless the drop is more than the premium received.

Let’s work through another example.

An investor goes short 1 ABC Sep 75 put @ $6. The market price falls to $69. What is the gain or loss?

When investing in puts, the breakeven can be found using this formula:

$\text{Short put breakeven}=\text{strike price}-\text{premium}$

You may notice this is the same breakeven formula used for long puts. Since the long and short sides are opposites, they reach breakeven at the same stock price.

With a strike price of $75 and a premium of $6, breakeven is $69 per share. At that market price, there’s no profit or loss.

The breakeven formula is also the same as a short put’s maximum loss formula. The difference is how you use it:

• Maximum loss is a dollar amount per share (and you multiply by 100 to get the per-contract amount).
• Breakeven is a stock price, so you don’t multiply by 100.

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If ABC’s market price doesn’t fall too far below $75, the investor can still make a profit. For example:

An investor goes short 1 ABC Sep 75 put @ $6. The market price falls to $74. What is the gain or loss?

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Expiration is the best-case scenario for investors writing (going short) options. If the option expires worthless, the investor keeps the premium and never has to fulfill the obligation. The same applies to short put contracts.

An investor goes short 1 ABC Sep 75 put @ $6. The market price rises to $84. What is the gain or loss?

Investors with short options can only make the premium, nothing more. If exercise occurs, losses start reducing the premium and can push the position into an overall loss.

$\text{Short put maximum gain}=\text{premium}$

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Writers can also perform closing transactions to exit their obligations before expiration.

An investor goes short 1 ABC Sep 75 put @ $6. After ABC’s market price rises to $79, the premium falls to $2, and the investor does a closing purchase. What is the gain or loss?

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Here’s a visual summarizing the important aspects of short puts:

You’ve now seen all four versions of options: long calls, short calls, long puts, and short puts. The following visual puts it all together: