You’ve been looking to start another income stream and have your eye on a particular security. One problem: You don’t have the cash to buy it. So you’re considering diving into a short put options strategy to try to generate some cash and possibly pick up the security.
If your move was prompted by a quick conversation with your buddy, no worries — but you’re not ready to dive in just yet. Here is everything you need to know to get started with short put options.
What is a Short Put Option?
A short put options strategy involves an investor selling, or writing, a put option on a security. If you’re selling, that means someone has to be buying, so in this case, the seller is said to be “short,” and the buyer is “long” the option.
Specifically, with a short put option, you’re selling the right for the buyer to sell short the put option’s underlying security on a specified date at a specified price — known as the strike price — set in the contract. The buyer doesn’t have to sell the underlying security before the contract expires, but you have to buy it if the holder decides to sell.
By writing a short put option, you’re betting that the security will remain above or at the strike price. That’s a risky call that requires you to be fairly certain of where the price of the underlying security is going.
Goals of Writing Short Put Options
Often, traders have two reasons to deploy a short put options strategy:
- Income Generation: You get the premium right away for selling a short put option.
- Acquire a Position in a Security: You get a chance to buy the security at a price closer to what you want.
A trader also just may be bullish on a security.
An Example of a Short Put Options Strategy
Here’s an example of ABC, a hypothetical company: ABC’s stock is trading at $35. You believe it can go even higher, but you want to buy it lower. So you write a short put option for $30 at a $3 premium. Because options contracts are in blocks of 100 shares, that means you get $300 immediately.
Then, you’re just waiting to see where the price of ABC’s stock goes and for the option to expire. If the price remains above your $30 strike price, the option becomes worthless when it expires and you pocket $300.
However, if ABC’s price declines below $30, you’ll have to buy the underlying stock at the strike price of $30 minus your premium from whoever bought your contract. If you believe ABC’s price will rebound, then you now own shares at a discount.
If the price of the security drops to zero, your maximum loss would be $2,700 in this case ($30-$3=$27 * 100 shares).
But say ABC stock is trading below the strike price at $29 and you no longer want to own the stock (or never did in the first place). You can go out and buy the option back. If the option is trading for a premium less than you sold it, say $1.50, you can buy the option back for $150, close the trade and still make a small profit.
The Risk of Selling Short Put Options
Being bullish on a security can pay off if the price of a security stays above your strike price. You get to pocket the premium from opening the position. But the position comes with significant risk.
You may want to acquire the underlying security at a better price than what it’s trading. But if it declines significantly or drops to zero, you could face a big potential loss.
Buying or Selling a Short Put Option
To sell a short put option, you can place a sell-to-open order with your broker. The order can then be filled at the buyer’s asking price or at the price you’re willing to accept. Once the broker completes the sale, the premium is placed in your options trading account.
Consider Using a Short Put Options Strategy
Options can be risky, but short put options can be a valuable strategy to generate income, buy stock at a lower price and improve the returns in your portfolio.
On the date of publication, Sarah Edwards did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
On the date of publication, the responsible editor did not have (either directly or indirectly) any positions in the securities mentioned in this article.
