Two Ways to Short Put Options

11/26/2010 12:01 am EST

Focus: OPTIONS

One of the bullish strategies in the armamentarium of the options trader is that of selling puts. The sales can be accomplished either as “naked” sales (aka selling “cash-secured” puts when cash is set aside for potentially buying the stock in the event of assignment), or as one of two legs of a vertical credit spread (aka a bull put spread, a put credit spread, or for those “in the know,” simply selling a put spread).

The essential end result of this position is that of being short puts. As a result of the short put position, the trader has fundamentally taken the position of an insurance broker and sold a contract to insure the counter party against a decline of variable degree in the price of the underlying. The magnitude of the “deductible” for the policy is determined by the strike price the trader has sold.

For example, the trader who sells a $55 strike put to another trader holding an underlying currently trading at $60 has essentially sold an insurance policy indemnifying the purchaser of that put for any losses incurred as a result of the underlying trading below the strike price for the term of the option contract purchased. To continue the insurance analogy, the purchaser of the put would have a $5 deductible. In return for issuing this insurance policy (in option lingo known as “writing” the contract), the seller receives a premium, which is credited to his account.

Naked put sales refer to simply selling the put as a single legged option trade without any additional hedging positions. The naked put seller has no rights whatsoever and has the non-negotiable obligation to purchase the stock for the strike price should a request be made. This one position encumbers a variable degree of trading capital in order to ensure that the trader would reasonably be able to fulfill his obligation to purchase the stock should the owner of the put elect to exercise the contract he has purchased. In absolute risk terms, also known as “Black Swan” risk, the total risk is from the strike price sold to zero less the initial credit received.

Another commonly used similar strategy is to sell a put spread. In this vehicle, the fundamental profit engine remains the short sale of the put at the selected strike price. However, as contrasted to the naked put sale, an additional position is taken to mitigate risk and, as a corollary, to reduce the margin encumbrance. The additional position is to buy the same number of put contracts at a lower strike price than those sold in the same expiration series of options. Since the higher put strike will always sell for more premium than the lower strike price costs to buy, this constitutes a credit spread. In this case, the Black Swan risk is crisply defined to the difference between the strike prices less the initial credit received.

For traders who focus on the yield (payoff) of a position, a successfully executed put credit spread will almost always result in a higher trade yield than the naked put sale because of the dramatically lower margin encumbrance. However, investment-oriented option traders will often use unhedged naked put sales to initiate long stock positions in underlying securities they wish to own at a cost basis lower than the current price since the assigned price will be the strike price sold less the initial credit received.

The potential use of option strategies for the knowledgeable trader allows an almost limitless array of choices of trade structure. This is why a fundamental and comprehensive knowledge of the nuances of strategies is so valuable; if you know the road map, it is much easier to arrive where you want to be.

By Bill Burton, contributor, MarketTaker.com

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