The mentality behind short-term put option strategies is probably different from the mentality behind short-term call options. Many times, option traders consider short-term put options mostly as a means of protection, whereas call options are often used only to generate additional income. That said, long and short put options can both generate additional income and offer protection.
What Are Short-Term Put Options?
If a trader buys a put option, he or she has the right to sell the underlying at a particular price (strike price) before a certain time (expiration). If a trader owns 100 shares of stock and purchases a put option, the trader may be able to protect the position fully or to some degree because he or she will have the right to sell the stock at the strike price by expiration even if the shares lose value.
Some investors only consider buying short-term puts or front-month and even weekly expiring puts for protection. There is a flaw to the reasoning of purchasing short-term put options as protection, however. Similar to short-term call options, the contracts have a higher option theta (time decay) and relying on short-term puts is not necessarily the best way to protect a straight stock purchase.
Although short-term puts may be cheaper than longer expiration puts, if an option trader was to continually purchase short-term puts as protection, it could end up being a rather expensive way to ensure the stock, particularly if the stock never declines to the short-term put’s strike price. If a put option with a longer expiration was purchased, it would certainly cost more initially, but time decay (premium eroding) would be less of a factor due to a smaller initial option theta. Protection is good but so is minimizing negative theta with a longer expiration.
Short Put Options Selling Strategy Explained
A cash-secured put is when an investor or trader sells a put. The trader does not own the put and then sells it later. The trader has no position and sells a put short. At the same time, the trader holds enough cash in his account in case the put is assigned. We’re going to look at an example, but let’s discuss this a moment.
Just as there’s a covered call and a naked call, there’s a cash-secured put and a naked put. A naked put is when a trader just simply sells a put. That can be a somewhat risky position. If the stock remains above the strike price of the put through expiration, the premium collected on the put is a profit. But if the stock falls below the strike price by expiration, the trader can get assigned on that put and therefore have to buy stock. The trader can also buy back the short put position before expiration or assignment. But if the underlying stock falls significantly the trader can lose a great deal of money. Short puts are basically the same as short calls. Your maximum profit on that option is the premium collected. But your maximum loss can be disproportionally high.
Support Plays a Big Part
Selling the short options close to a support or resistance area makes sense because support and resistance have a better chance of holding than being broken. When selling a put naked or as a cash-secured position, it makes sense to consider support as a guide for what strike to potentially sell. If a trader wants to be assigned from his or her cash-secured put position, the best-case scenario is to have the underlying close or just under the short strike. The position is assigned, and the credit received is maximized, lowering the cost of the position.
For a naked put position, if support holds (as it generally does) the underlying position will fight to stay above the support level leading to the put option expiring worthless with the put seller retaining all the premium.
Cash-Secured Put Example
Let’s say you have been watching Facebook Inc. (FB) and are interested in buying the stock if it drops below some support. Looking at the chart below, you find some potential support around the $340 level.
With about 2 weeks to go until expiration, you can sell a 340 put and bring in a credit of 2.15 as seen below.
If FB closes at $340 or higher at Oct-8 expiration, the credit of 2.15 ($215 in real terms) is yours to keep. If the stock closes below $340, you will be assigned the position with a cost of $337.85 (340 – 2.15) a share. The $337.85 level is the breakeven for this cash-secured put as well.
Final Words
There are always options when trading options, and naked or cash-secured puts are no different. Understanding the probabilities and risk/reward scenarios is critical in choosing the best path for you as an option trader.
John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.
