Short put options are preferred by many investors to sell at premiums and make a profit. Sellers of put options can make profits when the price of the underlying asset rises or remains the same during the given tenure. Selling short put options is a bullish trading strategy used by many. However, beginners must first understand the basics of short put options before making trades. Let us discuss what is a short put option is in detail.
What is a Short Put Option?
A short put option is selling a regular put option. Here, the seller is shorting the option. The seller of a short put option agrees to purchase the underlying asset from the person who holds the option at a predetermined strike price. The financial contract between the parties will also have an expiration or exercise date. The seller of the short put option anticipates that the underlying asset’s price will not go below the strike price. When the price falls below the strike price, the concerned party can obligate the investor to purchase underlying shares. It is crucial to note that giving the seller the obligation (but no right) to purchase the underlying asset at the strike price, shall the option be exercised.
Example of a Short Put
Short put option strategy can be a little confusing for novices. Let us understand the short put option with an example. Suppose you are a stock trader in India with a bullish approach. After fundamental and technical research, you conclude that the stocks of a company named ‘ABC’ will rise for the next few years. The current market price of a share is INR 500, and you believe it will go beyond INR 550 in the next few months. Since you have some insights into the future price movements, you will sell or write a put option.
Let us say you sell a put option with a strike price of INR 525 per share. On selling the put option to an investor named ‘X’, you collect a premium of INR 5 per share. Also, you have included 100 shares of ABC in the short put option. In such a case, INR 500 (5*100) will be the immediate profit on selling. It is the premium collected from X, which can help offset losses in the future (if any).
On the expiration date, the current market price of ABC’s share is INR 530. Since the spot or market prices have increased, X will not want you to buy shares at INR 525 from them. In such a case, X will ignore the financial contract to sell shares of ABC. Even when the investor ignores the option, you still have the premium as a profit. It is crucial to note that X will hold the right to exercise the short put option. If the spot price had gone below INR 525 on the expiration date, X would have forced you to purchase the shares at INR 525. When the prices rise or remain the same, in short put option, sellers make a profit.
How a Short Put Works?
A short put option is similar to any other financial contract. When you sell a short put option, you are agreeing to purchase the underlying asset (if obligated) at the strike price from the buyer of the short put. However, the seller of these does not hold the right to purchase securities at the strike price on the exercise/expiration date. The buyer of the short put option decides to exercise or ignore the financial contract.
A short put option strategy works effectively when you are expecting prices to rise or remain the same. When the underlying asset price rises above the strike price, the buyer of the short put will never exercise the option. As a result, you get to keep the premium collected while selling the short put option. The option will also not be exercised when the spot price is similar to the strike price or expiration date. Most investors indulge in this trading to collect premiums from buyers.
This type of option trading can result in a loss. Investors need to understand the risks of short put before making trades. When the underlying asset’s price goes below the strike price on the expiration date, the individual shorting the put option will end up in a loss. The investor holding the short put would prefer to sell the underlying asset at a higher price (strike price) than the current market price. When the short put holder exercises the option, investors have no choice but to purchase the underlying asset at the strike price, which is above the spot/current market price in this case.
Short Put Option Strategy
The short put option strategy is also known as the naked put strategy among investors. It involves selling a put option with an underlying asset, strike price, and an expiration date. The individual shorting the put option will hope for prices to increase to stay the same as the strike price. However, there are chances of a loss when the market price goes below the strike price on the expiration date. Investors shorting put options decide their premiums based on the price speculation and strike price. These premiums can help short put traders offset the losses in the future (if any).
Experts suggest that individuals must own the underlying assets or have access to them before shorting put options. The short put holder might exercise the option on the expiration date (when the spot price is less than the strike price). Settlement of the option becomes easier when you have the possession of underlying assets. Short put traders must also keep an eye on changing prices in the market. If the price of the underlying asset is continuously rising, the short put option is likely to be worthless. In such a case, you get to keep the premium collected from the buyer of the short put.
Risks of Selling Puts
Are you interested in options trading? If yes, selling, shorting, or writing puts can help make substantial profits. Selling or writing a short put can help collect premiums beforehand from the buyers. However, you must also know the risks of selling puts, which are:
No Exercise Rights
When you sell or short a put option, the right to exercise the financial contract lies with the buyer. You are obligated to follow the contract terms when the short put holder decides to exercise it.
Obligation to Purchase the Underlying Asset
When the strike price goes below the spot price on the expiration date, you will be forced to purchase the underlying asset.
Risk of Plummeting Prices
There is always a risk of dropping asset prices in the market. Since short put option trading is a bullish strategy, investors do not want the prices to fall.
Since the short put holder will not exercise the contract when the prices rise, your profit is limited to the premium.
Greater Loss Potential
You might incur a greater loss when the underlying asset’s price plummets with a high margin. Sell or write short put options after thorough research to avoid losses!