What is a shortcut?

When a trader writes a short put option to initiate an options transaction, it is referred to as a short put. The trader who writes the put option is short, while the trader who purchases it is long.

The premium, or option cost, is paid to the writer (short) of the put option, and the trader’s profit is capped at that premium.

Basics of the Short Put

An exposed or naked, put is another name for a short put. If the put option buyer exercises the option, the writer of the put option is required to buy shares of the underlying company.

If the price of the underlying drops below the short put option’s strike price, the holder of the short put might also suffer a sizable loss before the buyer exercises or the option expires.

Quick Put Principles

If a put is sold to initiate a transaction, this is known as a short put. The writer (seller) is paid more for writing an option in exchange for this activity. The option writer’s profit is capped at the premium they were paid.

Selling a put to start an option trade and open a position is not the same as purchasing an option and then selling it. In the latter case, closing a trade and locking in a profit or loss is done using a sell order. In the former case, the seller (writing) opens the put position.

When a trader starts a short put, they probably think the underlying price will continue to rise over the written option’s strike price. The put option will expire worthless, and the writer will pocket the premium if the underlying price remains above the strike price. The writer may suffer losses if the underlying price drops below the strike price.

To purchase the underlying securities, some traders may employ a shortcut. Let’s say, for instance, that you want to purchase a stock for $25, but it is now trading at $27. Selling a put option with a $25 strike implies that you will have to purchase the stock at $25, which you intended to do otherwise, should the price drop below $25. The payoff for writing the option was a premium that you got. You have lowered your buying price to $24 if you were paid a $1 premium for drafting the option. You maintain the $1 premium if the underlying price stays above $25.

Dangers Associated with Selling Puts

A short put has a maximum profit of the premium received, but a considerable risk is involved. The writer of a put must purchase the underlying at the strike price. If the price of the underlying falls below the strike price, the put writer might risk a substantial loss.

For instance, the put writer faces a $5 per share loss (minus the premium paid) if the put strike price is $25 and the underlying price drops to $20. To realize the loss, they may either let the option expire, which will result in the option being exercised and the put writer acquiring the underlying for $25, or they can close out the option deal (purchase an option to counter the short).

Further financial expenditures will be necessary if the option is exercised and the writer must purchase the shares. In this scenario, the trader must purchase $2,500 worth of stock ($25 x 100 shares) for each short put contract.

Briefly Stated Example

Assume that XYZ Corporation, a fictional stock now trading at $30 per share, has an optimistic investor. The investor thinks that over the following months, the stock will grow gradually above $40. The trader could purchase shares, but doing so would cost $3,000. While writing a put option yields revenue right now, purchasing the shares might result in a loss in the future if the stock price declines.

The investor writes a one-put option with a strike price of $32.50 and a three-month expiration date of $5.50. Therefore, if the stock closes at $32.5 or above at expiration, the maximum gain is just $550 ($5.50 x 100 shares). The maximum loss is $2,700, or $32.50 minus $5.50 times 100 shares. The maximum loss would occur if the underlying dropped to $0 and the put writer was required to purchase the shares for $32.50. The premium gained from selling the option partly offsets the maximum loss.

Conclusion

• When traders write a put option on a security, they do a short put.
• The purpose of a short put is to collect the premium connected with a short put sale to benefit from a rise in the stock’s price.
• As a result, the option writer will lose money if the price drops.