The is the fourth of four articles on the basic elements that provide the foundation for all Option Trading. These elements include: The Long Call, the Short Call, the Long Put, and the Short Put. By combining Calls and Puts in creative fashions, Options traders are able to generate income strategies and limit risk. This article introduces the fourth such element, the Short Put.
Each element contains the prospects of producing Cash Flow with a greater or lesser degree of risk. Like the Short Call, the Short Put’s risk is limited to the purchase price of the Put. It is a bullish to neutral strategy that anticipates that the stock or underlying security will increase in value.
The Risk Graph below illustrates the risk of the Short Put:
Short Put
The Put writer receives the premium from the sold Put. Even if the stock increases in value, the premium remains the same for the Put seller who sold it at that price.
Selling a Put without owning or shorting the underlying security is known as a “Naked� Put. The Put is considered Naked because it is not “Covered� by having purchased the underlying stock or security. Buying the stock and buying the Put at the same time is known as creating a Married Put. If you short the stock and sell a Put, it is called a Covered Put. These Option Strategies will be discussed at another time.
The risk associated with a Naked or Short Put is said to be unlimited, but the stock can only go to zero. If the stock closes above the Strike Price of the short Put, then the Put writer keeps all the premium sold on that Option. If the stock falls below the Strike Price, the Put seller is required to purchase an equal number of shares of stock at the Strike Price of the sold Put.
We do not advise selling Naked Puts at all. The risk is simply too great. Imagine shorting Puts on a stock that is larger than the amount you have in your account. The stock could be $100 and you sold 10 contracts. You would have to pony up $100,000 to purchase the stock. If your account is $50,000, you are in real trouble. Hopefully, there would be broker enforced account safeguards that would prevent you from placing such a trade. The prospect of emptying your trading account is real when you sell Naked Puts.
Yes, you can make money trading this strategy. You can create Cash Flow. In our opinion, it is just not worth the risk. There are much less risky Cash Flow Option strategies than selling Naked Puts.
Learning how At-the-Money and Out-of-the-Money Short Puts work with time decay and implied volatility is important and useful information. It is valuable for creating spread trades such as Bear Put Spreads and Calendar Spreads. As I indicated at the beginning of this article, understanding how each of these four Option elements work is essential for creating combinations that will produce Cash Flow, and do so with minimal risk.
