Short puts

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 (the put is “in the money”), the holder may exercise the option. That forces the writer to buy shares 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. 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 ABC 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. They typically ask for 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 by utilizing this formula:

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

The strike price of $75 minus the premium of $6 leaves the investor with 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 scenario, 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)
• Bank guarantee letter**

*For a long put to cover a short put, the long put must maintain the same or higher strike price, plus the expiration must be the same or longer.

**A short put is considered covered if a banking institution provides a guarantee letter stating it will cover the costs related to an assignment.

The risk of a short put comes from being forced to buy shares at the strike price when the market price is lower.

• If the investor is short the shares, the sale already occurred. When the put is assigned, the investor effectively buys back the short shares, which closes the short position. The investor doesn’t have to worry about selling later at a lower price because the shares were already sold short.
• If the investor owns a put (in addition to the short put), they have the right to sell the shares purchased at assignment at the long put’s strike price. If the market price drops sharply, they can exercise the long put and sell at the higher strike price.
• While cash doesn’t prevent losses, posting cash equal to the maximum loss technically “covers” the put because the account has enough funds to meet the assignment obligation. Remember that cash cannot cover a short call because its risk is unlimited.

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Let’s look at an example that is 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 until the decline exceeds 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 probably noticed 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, the investor breaks even when ABC stock is at $69 per share.

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

• Maximum loss is a dollar loss per share (and you multiply by 100 for one contract).
• 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 could 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 eating away at the premium and can turn the position into a net 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 been through all four versions of options: long calls, short calls, long puts, and short puts. The following visual puts it all together:

Key points

Short puts

• Bullish investments
• Obligation to buy the stock at the strike price
• Considered “naked” without a hedge
• Short puts can be covered by:
  • Short shares
  • Long put
  • Cash
  • Bank guarantee letter

Short put formulas

• Maximum gain = premium
• Maximum loss = strike - premium
• Breakeven = strike - premium