Short Puts: 5 Questions To Ask Before You Trade Them
The first time I ever heard about a short put was through my financial advisor in the 1990’s. He said, “How would you like to enter a stock position at a discount? By selling a put you receive money into your account, and can continue doing this time-after-time until you finally get into the long position.”
As a completely naïve options investor, I heard the words but didn’t really know how to begin asking questions about it. The buzz word that stuck in my mind was, “discount.” There was zero mention of any risk in his comment, so I didn’t think that was even a minor concern.
Now, after studying options rights and obligations and being guided by several professional options instructors, I have a much better understanding and am clear about the list of questions that must be considered before trading Short Puts.
● How do you calculate the risk?
● What action could be taken to reduce the risk?
● If I’m looking to get into the long stock, how long does it take?
● Is there any period of time where this strategy to enter a stock position “at a discount” is not advisable?
● What if I change my mind after my money is committed to the strategy?
Short Put: Entering a short put means that you are selling a put. There are no rights given with this contract, however, by selling the put you are taking on a potential obligation to buy the stock.
How do you calculate the risk?
By selling the Short Put you receive a credit which is the amount per share noted under the BID column of the options chain per strike price. To calculate the RISK you subtract the credit amount from the strike price. No matter how far the fair-market-value falls, you are obligated to buy the stock at the strike price. You get to keep the credit that you received upon entry, but may see a big loss anyway.
Example: If XYZ stock is trading near $50.00 and you sell the $50.00 strike put for $1.75 per share, the risk is $48.25 (50 - 1.75) per share. What if the stock price falls to $40.00? The loss at that level is $8.25!
What action could be taken to reduce the risk?
By adding a Long Put at a strike price below the strike price of the Short Put, that reduces the risk significantly, but also reduces the amount of credit received. Ex: If you entered the $50.00 Short Put for $1.75 and also the $45.00 Long Put for $0.75, the income (credit) you receive will be reduced to $1.00 per share, but the risk is also greatly reduced. You still have the obligation to buy the stock at $50.00, but also the Long Put Option gives you the right to SELL the stock at $45.00. The risk calculation is this: the difference in the strike prices ($5.00) minus the net credit ($1.00) equals the maximum risk ($4.00.) Much better than a risk of $48.25!
If I’m looking to get into the long stock, how long does it take?
Unknown. However, by repeating the process while the stock is not dropping in price it is pure income.
Is there any period of time where this strategy to enter a stock position “at a discount” is not advisable?
Yes! When the market is weak and moving toward a Bear Market most all the stocks will drop in price, raising the risk to all investors.
What if I change my mind after my money is committed to the strategy?
Investing is linked with legal, financial responsibilities. There may be an exit without a penalty, but most option investors wouldn’t feel the need to get out of the position unless the stock price was dropping. When a price drop prompts an investor to get out of the commitment, it usually costs a penalty.
As with anything, the more you know, the better you are at using the tools to your advantage. Who knows what the market will do in the future? The best thing an investor can do is learn to manage their risk!
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