THE OPTIONS COURSE- SHORT PUT

THE OPTIONS COURSE



SHORT PUT

A short put strategy offers limited profit potential and limited, yet high risk. It is best placed in a bullish market when you anticipate a rise in the price of the underlying market beyond the breakeven. By selling a put option, you will receive the option’s premium in the form of a credit into your trading account. The premium received is the maximum reward for a short put position. In most cases, you are anticipating that the short put will expire worthless.

A short put strategy creates a risk profile that slants downward from right to left from the limited profit. Notice that as the price of the asset falls, the loss on the short put position increases (until the price of the underlying stock hits zero). Additionally, the profit is limited to the initial credit received for selling the put. When the underlying instrument’s price rises, you make money; when it falls, you lose money. This strategy provides limited profit potential with limited risk (as the underlying can only fall to zero). 

It is often used to get high leverage on an underlying security that you expect to increase in price. As explained earlier, when you sell options, you will initially receive the premium for which you sold the option in the form of a credit into your account. The premium received is the maximum reward. The maximum loss is limited to the downside until the underlying asset reaches zero. What kind of a view of the market would you have to sell puts? You would have a bullish or neutral view. 

The breakeven for initiating the trade is the strike price at which the puts are sold minus the premium received. If the market were to rise, the position would increase in value to the amount of premium taken in for the puts. Looking at the risk graph, notice that as the price of the asset falls, the loss of your short put position increases. This strategy requires a heavy margin deposit to place and is best placed using short-term options with high implied volatility, or in combination with other options.

FIGURE  Short Put Risk Graph

Short Put Mechanics

Let’s create an example by going short 1 January XYZ 50 Put @ 5. The maximum profit on this trade is equal to the amount received from the option premium, or $500 (5 × 100 = $500) minus commissions. To calculate the breakeven on this position, subtract the premium received from the put strike price. In this case, the breakeven is 45 (50 – 5 = 45). If XYZ rises above $45, the trade makes money. 

You earn the premium with the passage of time as the short option loses value. A short put strategy creates a risk profile that slants downward from right to left. Notice that as the price of the asset falls, the loss of your short put position increases until the price of the underlying stock hits zero. This signifies that the profit increases as the market price of the underlying rises.

Exiting the Position

A short put strategy offers three distinct exit scenarios. Each scenario primarily depends on the movement of the underlying shares.

• XYZ rises above the put strike price (50): This is the best exit strategy. The put expires worthless and you get to keep the premium, which is the maximum profit on a short put position.
• XYZ reverses and starts to fall toward the breakeven (45): You may want to offset the position by purchasing a put option with the same strike price and expiration to exit the trade.
• XYZ falls below the put strike price (50): The short put is assigned and the put writer is obligated to buy 100 shares of XYZ at $50 per share from the put holder. The short put seller now has a long shares position and can either sell the XYZ shares at a loss or wait for a reversal. The maximum loss occurs if the price of XYZ falls to zero. The short put writer then loses $5,000 (100 shares × 50 = $5,000) less the $500 credit received from the premium, or a total loss of $4,500 (5,000 – 500 = $4,500).

Short Put Case Study

When we buy a put, we want the underlying security to move lower. Thus, when we sell a put, we want the stock to rise. However, our maximum profit is the premium we receive for selling the put, so if we expect a large move higher in the stock, we would be better off to buy a call. Selling a put is best used when we expect a slightly higher price or consolidation to take place. When a stock falls sharply to support in one or two sessions, this is often a good time to look at selling puts. 

If we expect that the stock might start to consolidate following a decline, selling a put could provide nice profits. However, the risk remains rather high because the stock could continue to fall and a put seller is at risk the whole way down to zero. On July 31, 2003, shares of Cardinal Health (CAH) fell $10 to about $55 a share. This drop might have seemed overdone given the circumstances and a trader could have entered a short put near the close of the session. 

The August 55 put could be sold for $1.65, which means selling five contracts would bring in $825.  We want to use the front month option because time value works in our favor.  If CAH were to stay at $55 or move higher by August 15, the trader would receive the maximum profit. This means that margin will be an issue and that a large amount of margin will be needed to enter this type of trade. The breakeven point for this trade is calculated by subtracting the credit received from the strike price (55 – 1.65 = 53.35). 

Thus, even a slight move lower would still generate a profit in this trade, but if CAH were to fall below $53.35 the losses would start to grow. Fortunately, shares of CAH did move higher after this decline, leaving the trader with the maximum profit of $825 from the sale of five puts. Later, we will talk about a less risky way to profit using spreads instead of naked options.


FIGURE  Risk Graph of Short Puts on CAH 

COVERED PUT

You can also use a covered put in a bearish market to profit from a possible increase in a short stock or futures position. A covered put consists of selling the underlying futures or stock position and selling a put to cover the underlying asset’s position. This trade can be very risky, because it involves short selling a stock, which requires a high margin. The reward on a covered put is limited to the difference in the initial price of the short underlying asset minus the strike price of the short put plus the credit received for the option premium.

Covered Put Mechanics

In this example, let’s go short 100 shares of XYZ @ 50 and short 1 June XYZ 45 Put @ 2.50. The risk graph below shows a covered put position at expiration. Once the market moves to the upside above the breakeven, there is unlimited risk. Margin is $7,500 (stock price plus 50 percent more); however, the credit on the short stock is $5,000. In addition, the credit on the short put is $250. Total credit is $5,250. The maximum reward on this trade occurs if XYZ closes at or below 45 at expiration. 

The maximum profit for this trade is $750: (50 – 45) + 2.50 × 100 = $750. As with most short strategies, this trade is hazardous because it comes with unlimited risk. The breakeven of a covered put strategy equals the price of the underlying asset at trade initiation plus the option premium. In this trade, the breakeven is 52.50: (50 + 2.50 = 52.50). That means that if XYZ moves above $52.50, the trade will lose $100 for each point it rises. In fact, the higher the underlying asset climbs, the more money will be lost.

FIGURE  Covered put Risk Graph 

Exiting the Position

Since a covered put protects a stock only within a specific range, it is vital to monitor the daily price movement of the underlying stock. Let’s investigate optimal exit strategies in the following scenarios:

• XYZ declines below the short strike price (45): The short put is assigned and you are obligated to buy 100 shares of XYZ from the option buyer at $45 per share. However, you can unload these shares for the short share price of $50. This exit process garners the maximum profit of $750.
• XYZ declines below the initial stock price (50), but remains above the short strike price (45): The short put expires worthless and you get to keep the premium received. No losses have occurred on the short stock position and you are ready to place another covered put to bring in additional profit on the position if you wish.
• XYZ rises above the initial stock price (50) but stays below the breakeven (52.50): The short stock position starts to lose money, but this loss is offset by the credit received from the short put. As long as the stock stays below the breakeven, the position will break even or make a small profit.
• XYZ rises above the breakeven (52.50): Let the short put expire worthless and use the credit received to partially hedge the loss on the short stock position.

Both covered calls and covered puts are high-risk strategies, although they can be used to try to increase the profit on a trade. It is essential to be aware of the risks involved and to be extremely careful in selecting the underlying markets for your covered call or put writing strategies.

Covered Put Case Study

A covered put can be used to profit in the short term by going short a stock and then selling a put to bring in additional income. The reason a covered put is not a suggested strategy for most traders is because it has unlimited risk. The sale of the put does help offset the cost of the short stock, but if the stock rises, this income might mean very little. Let’s use Rambus (RMBS) once again to show how a covered put would have worked for this stock when compared to a covered call.

By entering a short put, we have limited risk to the downside all the way to zero. At the same time, we have unlimited risk to the upside and a large margin requirement for selling the stock short. Let’s assume we didn’t already own Rambus, so we need to sell short 500 shares at $30 and sell five December 30 puts. Remember, RMBS shares were trading right at $30 a share, so we would be able to keep the entire premium from the put if the stock closes at or above this point. However, as the stock declines, we profit from being short on Rambus.

The December 30 puts could be sold for 2.10 each and Rambus shares could be sold short for $30 a share. Thus, we would receive a credit of $16,050 for entering the covered put. However, the maximum profit would be limited to just $1,050. Notice how the risk continues to grow as the stock moves higher. This is because the amount of money brought in from selling the put does little to offset the potential loss obtained from selling RMBS shares short. However, no matter how low the stock moves, our maximum profit is achieved because the gain in the short stock will offset the loss in the short put.

In our example, shares of RMBS did try several times to break higher, but each time resistance held and the stock ultimately closed at 26.37 on expiration (December 19). This would have resulted in the maximum profit of $1,050. The short put would have had a value of 3.70 to buy back on expiration. This results in a loss of 1.60 each (or $800 for five contracts) for the put. However, the 500 shares of RMBS sold short are now showing a profit of 3.63: (30 – 26.37). This means the profit from the short stock is $1,815: (3.63 × 500).

If the option were not bought back, the trader would be forced to buy shares to cover the short, but the net result would still be a profit. This might seem like a good way to bring in premium on a stock expected to move lower. However, the margin required would be large and the risk is normally just too high to be a consistently profitable strategy.


FIGURE  Risk Graph of Covered Put on RMBS 

STRATEGY ROAD MAPS

For your convenience, the following subsections provide step-by-step analyses of the basic strategies.

Long Call Road Map

In order to place a long call, the following 13 guidelines should be observed:

1. Look for a low-volatility market where a rise in the price of the underlying stock is anticipated.
2. Check to see if this stock has liquid options available.
3. Review options premiums with various expiration dates and strike prices. Use options with more than 90 days until expiration.
4. Investigate implied volatility values to see if the options are overpriced or undervalued. Look for options with low implied volatility.
5. Review price and volume charts over the past year to explore price trends and liquidity.
6. Choose a long call option with the best profit-making probability. Determine which call option to purchase by calculating:
  • Limited Risk: Limited to the initial premium required to purchase the call.
  • Unlimited Reward: Unlimited to the upside as the underlying stock rises above the breakeven.
  • Breakeven: Call strike + call premium.

7. Create a risk profile for the trade to graphically determine the trade’s feasibility. The long call’s risk profile slants upward from left to right.
8. Write down the trade in your trader’s journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.
9. Make an exit plan before you place the trade. Determine a profit and loss percentage that will trigger an exit of the position. Close out the entire trade by 30 days to expiration.
10. Contact your broker to buy the chosen call option. A margin deposit is not required.
11. Watch the market closely as it fluctuates. If the market continues to rise, hold onto the call option until you have made a satisfactory profit or a reversal seems imminent.
12. If the underlying market gives a dividend to its stockholders, this will have a negative effect on the price of a call option because a dividend usually results in a slight decline in the price of a stock.
13. Choose an exit strategy based on the price movement of the underlying stock and the effects of changes in the implied volatility of the call option:
  • The market rises above the breakeven: Offset the position by selling a call option with the same strike price and expiration at an macceptable profit; or exercise the option to purchase shares of the underlying market at the lower strike. You can then hold these shares as part of your portfolio or sell them at a profit at the current higher market price.
  • The market falls below the breakeven: If a reversal does not seem likely, contact your broker to offset the long call by selling an identical call to mitigate your loss. The most you can lose is the initial premium paid for the option.


Short Call Road Map

In order to place a short call, the following 13 guidelines should be observed:

1. Look for a high-volatility market where a fall in the stock’s price is anticipated.
2. Check to see if this stock has liquid options available.
3. Review options premiums with various expiration dates and strike prices. Options with less than 45 days until expiration are best.
4. Investigate implied volatility values to see if the options are overpriced or undervalued. Look for options with high implied volatility and, thus, a higher premium.
5. Review price and volume charts over the past year to explore price trends and liquidity.
6. Choose a short call option with the best profit-making probability. Determine which call option to sell by calculating:
  • Unlimited Risk: Unlimited to the upside as the underlying stock rises above the breakeven.
  • Limited Reward: Limited to the initial call premium received as a credit.
  • Breakeven: Call strike + call premium.

7. Create a risk profile for the trade to graphically determine the trade’s feasibility. A short call’s risk profile slants down from left to right showing the limited profit and unlimited risk as the stock rises.
8. Write down the trade in your trader’s journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.
9. Make an exit plan before you place the trade. Determine a profit and loss percentage that will trigger an exit of the position. For example, a 50 percent profit or loss is an easy signal to exit the position.
10. Contact your broker to go short (sell) the chosen call option. Margin is required to place a short call, the amount of which depends on your broker’s discretion.
11. Watch the market closely as it fluctuates. If the price of the underlying stock rises above the strike price of the short call option, it is in danger of being assigned. If exercised, the option writer is obligated to deliver 100 shares (per option) of the underlying asset at the short call strike price to the option holder.
12. If the underlying market gives a dividend to its stockholders, this will usually cause the price of the call option to decline slightly, which works in favor of the short call strategy.
13. Choose an exit strategy based on the price movement of the underlying stock and the effects of changes in the implied volatility of the call option:
  • The market falls below the strike price: Wait for the call to expire worthless and keep the credit received from the premium.
  • The market reverses and begins to rise above the call strike price: Exit the position by offsetting it through the purchase of an identical call option (same strike price and expiration date) to avoid assignment.

Covered Call Road Map

In order to place a covered call, the following 13 guidelines should be observed:

1. A covered call is a conservative income strategy designed to provide limited protection against decreases in the price of a long underlying stock position. Look for a range-bound market or a bullish market where you anticipate a steady increase in the price of the underlying stock.
2. Check to see if the stock has liquid options.
3. Review call option premiums and strike prices no more than 45 days out.
4. Investigate implied volatility values to see if the options are overpriced or undervalued. Look for expensive options to get the most out of selling the call.
5. Explore past price trends and liquidity by reviewing price and volume charts over the past year.
6. Choose a higher strike call no more than 45 days out to sell against long shares of the underlying stock and then calculate the maximum profit, which is limited to the credit received from the sale of the short call plus the profit made from the difference between the stock’s price at initiation and the call strike price.
7. Determine which spread to place by calculating:
  • Limited Risk: Limited to the downside as XYZ can only fall below the breakeven to zero.
  • Limited Reward: Limited to the credit received from the short call plus the strike price minus the initial stock price.
  • Breakeven: Calculated by subtracting the short call premium from the price of the underlying stock at initiation.

8. Create a risk profile of the most promising option combination and graphically determine the trade’s feasibility. Note the unlimited risk beyond the breakeven.
9. Write down the trade in your trader’s journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.
10. Make an exit plan before you place the trade. You must be willing to sell the long stock at the short call’s strike price in case the call is assigned.
11. Contact your broker to buy and sell the chosen options. Place the trade as a limit order so that you limit the net debit of the trade.
12. Watch the market closely as it fluctuates. The profit on this strategy is unlimited—a loss occurs if the underlying stock closes at or below the breakeven points. You can also adjust the position back to a delta neutral to increase profit potential.
13. Choose an exit strategy depending on the movement of the underlying stock:
  • The price of the stock rises above the short strike: The short call is assigned and exercised by the option holder. You can then use the 100 shares from the original long stock position to satisfy your obligation to deliver 100 shares of the underlying stock to the option holder at the short call strike price. This scenario allows you to take in the maximum profit.
  • The price of the stock falls below the short call strike price, but stays above the initial stock price: The short call expires worthless and you get to keep the premium received. No losses have occurred on the long stock position and you are ready to sell another call to offset your risk.
  • The stock falls below the initial stock price but stays above the breakeven: The long stock position starts to lose money, but this loss is offset by the credit received from the short call. As long as the stock does not fall below the breakeven, the position will break even or make a small profit.
  • The stock falls below the breakeven: Let the short option expire worthless and use the credit received to partially hedge the loss on the long stock position.


Long Put Road Map

In order to place a long put, the following 13 guidelines should be observed:

1. Look for a low-volatility market where a steady decrease in price is anticipated.
2. Check to see if this stock has liquid options available.
3. Review options premiums with various expiration dates and strike prices. Use options with more than 90 days to expiration.
4. Investigate implied volatility values to see if the options are overpriced or undervalued. Look for options with low implied volatility.
5. Review price and volume charts over the past year to explore past price trends and liquidity.
6. Choose a long put option with the best profit-making probability. Determine which option to buy by calculating:
  • Limited Risk: Limited to the initial premium required to purchase the put option.
  • Limited Reward: Limited to the downside as the underlying stock can only fall to zero.
  • Breakeven: Put strike – put premium.

7. Create a risk profile for the trade to graphically determine the trade’s feasibility. The profit/loss line slopes up from right to left.
8. Write down the trade in your trader’s journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.
9. Make an exit plan before you place the trade. Determine a profit and loss percentage that will trigger an exit of the position. Close out the entire trade by 30 days to expiration.
10. Contact your broker to buy the chosen put option. A margin deposit is not required.
11. Watch the market closely as it fluctuates. If the market continues to fall, hold onto the put option until you have hit your target profit or a reversal seems imminent.
12. If the underlying market gives a dividend to its stockholders, this will have a positive effect on the price of a put option because a dividend usually results in a slight decline in the price of a stock.
13. Choose an exit strategy based on the price movement of the underlying stock and the effects of changes in the implied volatility of the put option:
  • The underlying stock falls below the breakeven: Either offset the long put by selling a put option with the same strike and expiration at an acceptable profit or exercise the put option to go short the underlying market. You can hold this short position or cover the short by buying the shares back at the current lower price for a profit.
  • The underlying stock rises above the breakeven: You can wait for a reversal or offset the long put by selling an identical put option and using the credit received to mitigate the loss. The most you can lose is the initial premium paid for the put.


Short Put Road Map

In order to place a short put, the following 13 guidelines should be observed:

1. Look for a high-volatility market where an increase or steady rise is anticipated.
2. Check to see if this stock has liquid options available.
3. Review options premiums with various expiration dates and strike prices. Options with less than 45 days to expiration are best.
4. Investigate implied volatility values to see if the options are overpriced or undervalued. Look for options with high implied volatility, and thus a higher premium.
5. Review price and volume charts over the past year to explore past price trends and liquidity.
6. Choose a short put option with the best profit-making probability. Determine which put option to sell by calculating:
  • Limited Risk: Limited to the downside below the breakeven as the underlying stock can only fall to zero.
  • Limited Reward: Limited to the initial put premium received as a credit.
  • Breakeven: Put strike – put premium.

7. Create a risk profile for the trade to graphically determine the trade’s feasibility. The risk graph slopes down from right to left, showing a limited profit.
8. Write down the trade in your trader’s journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.
9. Make an exit plan before you place the trade. Determine a profit and loss percentage that will trigger an exit of the position.
10. Contact your broker to sell the chosen put option. This strategy requires a margin deposit; the amount depends on your broker’s discretion.
11. Watch the market closely as it fluctuates. If the price of the underlying stock falls below the short strike price, it will most likely be assigned. If exercised, the option writer is obligated to purchase 100 shares of the underlying asset at the short strike price (regardless
of the decrease in the price of the underlying stock) from the option holder.
12. If the underlying market gives a dividend to its stockholders, this will have a negative effect on the price of a short put because a dividend usually results in a slight decline in the price of a stock.
13. Choose an exit strategy based on the price movement of the underlying stock and the effects of changes in the implied volatility of the put option:
  • The underlying stock continues to rise or remains stable: Wait for the option to expire worthless and keep the credit received from the premium.
  • The underlying stock reverses and starts to fall: Exit the position by offsetting it through the purchase of an identical put option (same strike price and expiration date) to avoid assignment.

Covered Put Road Map

In order to place a covered put, the following 13 guidelines should be observed:

1. Look for a range-bound market or bearish market where you anticipate a slow decrease in the price of the underlying stock.
2. Check to see if this stock has options.
3. Review put option premiums and strike prices no more than 45 days out.
4. Explore past price trends and liquidity by reviewing price and volume charts over the past year.
5. Investigate implied volatility values to see if the options are overpriced or undervalued.
6. Choose a lower strike put no more than 45 days out to sell against short shares of the underlying stock.
7. Determine which trade to place by calculating:
  • Unlimited Risk: The maximum risk is unlimited to the upside above the breakeven. Requires margin to place.
  • Limited Reward: The maximum profit is limited to the credit received from the sale of the short put option plus the profit made from the difference between the stock’s price at initiation and the short put strike price.
  • Breakeven: Calculated by adding the short put premium to the price of the underlying stock at initiation.

8. Risk is unlimited to the upside as the underlying asset rises above the breakeven. Create a risk profile for the trade to graphically determine the trade’s feasibility.
9. Write down the trade in your trader’s journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.
10. Choose your exit strategy in advance. How much money is the maximum amount you are willing to lose? How much profit do you want to make on the trade?
11. Contact your broker to sell the stock and sell the chosen put option against it. Choose the most appropriate type of order (market order, limit order, etc.). This strategy will require a large margin to place, depending on your brokerage’s requirements.
12. Watch the market closely as it fluctuates. The profit on this strategy is limited. Keep in mind that an unlimited loss occurs if and when the underlying stock rises above the breakeven point.
13. Choose an exit strategy:
  • The price of the stock falls below the short put strike price: The short put is assigned to an option holder. You can then use the 100 shares you are obligated to buy at the short put strike price to cover the original short stock position. This scenario allows you to take in the maximum profit.
  • The price of the stock rises above the short strike, but stays below the initial stock price: The short put expires worthless and you get to keep the premium received. No losses have occurred on the short stock position and you are ready to place another short put position to bring in additional profit on the short stock position if you wish.
  • The price of the stock rises above the initial stock price, but stays below the breakeven: The short stock position starts to lose money, but this loss is offset by the credit received from the short put. As long as the stock doesn’t rise above the breakeven, the position will break even or make a small profit.
  • The price of the stock rises above the breakeven: Let the short put expire worthless and use the credit received to partially hedge the increasing loss on the short stock position.

CONCLUSION

Having been involved in teaching options strategies for more than a decade, I’m still amazed by the lack of knowledge pertaining to what I believe is the most flexible investment vehicle available: the option. The number one question I receive from publications, individual investors, and almost everyone I meet is: Why should anyone trade options? After all, options are so risky. This line of reasoning makes me cringe. It’s obvious that educators, brokers, and the overall investment community simply haven’t done a good enough job informing investors of the benefits of trading options. 

Yes, there are risks if you haven’t taken the time to learn how to trade options. But that goes for stocks, too! Knowledge is power. In my opinion, every trader should attain enough knowledge to be able to make informed decisions about whether to include options as part of their investment arsenals. The initial eight strategies r—long stock, short stock, long call, short call, covered call, long put, short put, and covered put—are the fundamental building blocks of intermediate and advanced trading techniques. It is absolutely essential to your success as an options trader to develop a solid understanding of these basic strategies.

 Your knowledge level is what will ultimately determine how successful you will be. The primary reason that beginning traders do not last is because they do not educate themselves enough. The more knowledge you have in your field, the more confidence you have, and that will inevitably enhance your trading results. I am still learning and trying to increase my trading savvy on a daily basis. This is the type of hunger for knowledge that you need to have—not only to thrive, but also to survive in the volatile markets of the twenty-first century. Covered calls are the most popular option strategy used in today’s markets. 

If you want to gain additional income on a long stock position, you can sell a slightly OTM call every month. The risk lies in the strategy’s limited ability to protect the underlying stock from major moves down and the potential loss of future profits on the stock above the strike price. Covered calls, however, can be combined with a number of bearish op- tions strategies to create additional downside protection. While covered calls are a very popular strategy, covered puts enable traders to bring in some extra premium on short positions, but with high risk involved. 

Once again, you can keep selling a put against the short shares every month to increase your profit. However, shorting stock is a risky trade no matter how you look at it because there is no limit to how much you can lose if the price of the stock rises above the breakeven. There are many other ways to take advantage of a stock’s bearish movement, using options to limit the trade’s risk and maximize the leveraging ability of your trading account. 

Covered writes also enable traders to weather moderate price fluctuations without accumulating losses. This should help reduce stress; any technique that helps to reduce stress is a worthwhile addition to a trader’s arsenal. To gain added protection, try buying a long put against a covered call or a long call against a covered put. The extra outlay of premium acts as an insurance policy, and that could mean the difference between losing a little on the premium versus taking a heavy loss in a volatile market.

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