Playbook: Basis: the Short Put

Short (Naked) Put

The short put (or ‘naked put’) is the opposite of the short call and looks like the long call since it is also bullish. It is a simple, short-term income strategy (generating income on a regular basis). Such strategies are typically short-term. Option premium is sold on a monthly basis.

A put is an option to sell. The seller has the obligation to take the other side (sell the put). The buyer of the put option has a right to take delivery (of the put).

So, selling/shorting a put means that the seller has the obligation to sell the obligation to sell the put. The buyer of the put has a right to take delivery of the obligation (the put). In other words, when you sell a put, you have sold someone the right to sell. You may need some time to think this over :).

The position benefits from IV/IVR contraction and/or underlying price decreases below the strike.

Considerations

General

The reason for selecting this option strategy is that you expect the underlying to rise and be ‘In The Money’ (ITM: stock > short put strike price) and to pick-up short-term premium. So, you sell puts in a down move (into strength). Alternatively, you sell short puts if you want to own the shares at lower cost.

Initially, selling a put results in less exposure to the stock than buying/long 100 shares outright.

These are the considerations for entering a short put:

• The expectation that underlying (stock, ETF, index, future) will rise or go sidewards: the outlook is clearly bullish, looking for options to increase in value over time.
• Selling premium is expensive.
• Collecting premium over time as ‘income.’
• Instead of buying stock/shares outright.
• Seeking discounted ‘assigned’ long stock.
• Hedging against short/bearish positions.
• Adding positive theta to the portfolio.
• Adding a bullish leg to existing (e.g. long) strategies to limit risk.
• The underlying has just experienced a pullback/decline.
• Implied Volatility (IV)/IVR (IV Rank) is high (>30).
• The maximum reward is limited to the premium.
• Risk is unlimited to zero.

When you sell a (put or call) option, time (value) decay helps, so typically, expiration dates should be reasonably not too far away (ideally around 45 DTE, so in the last month before the option’s expiration); so the period of trade is one month or less.

BPR can extend when tested. Your maintenance in the tastytrade dashboard is your max loss.

Description

Set-Up

1. ‘ Sell to open’ (STO) one put option at 30Δ OTM for every 100 shares long.

Please note that 30Δ is equivalent to 30 shares of exposure, reducing risk to the downside if the underlying price decreases.

Another method is buying deep ITM call options. Calls are ITM if price underlying > call strike.

Related Options Strategies

The short put is one of the four basic options strategies on which all other strategies are built, especially options strategies with long call legs: vertical, calendar, and diagonal spreads, condors, butterflies, reverse straddles and strangles, etc.

The short put is equivalent to having 100 shares long in underlying plus a short call (called a’ synthetic short put‘)

The Greeks

Entry Rules

Profitable short puts require correctly selecting bullish underlyings AND good timing.

Sell into down move.

Criteria

• Acknowledge whether market sentiment allows trade.
• Check whether trade fits in portfolio allocation rules.
• Ensure stock meets all of your selection criteria (volume, open interest, ask-bid range, etc.).
• IV/IVR above 30%.
• Ensure the trend is upward/bullish.
• Ensure at least three of the technical momentum indicators are positive.
• Identify the clear areas of support and resistance.
• Make sure there are no major events (dividends, earnings) within 30 days of the expiry date.
• Profitability of Profit at selected strike: around 50%.
• Backtest (since 2006 and last 200 trades): at least $1.00 (average and mean) profit/day.

Technical Indicators Used

1. Trend = bullish
2. Support & Resistance = the underlying has just experienced a pullback/decline to a clear support level
3. RSI = oversold
4. Bollinger Bands in combination with Keltner Squeeze: at the bottom and outside Keltner bands
5. ADX/DMI: increasing up and above 20
6. ATR high

P/L and Risk Profile

Net Position

Net credit, because you get a premium when selling the put option.

Theoretical Profit

Time decay works positively with your sold put option. It will be eroding the value of your put every day, so all other things being equal, the put you sold will be declining in price every day, allowing you to buy it back for less than you bought it for unless the underlying stock has fallen, of course.

The reward is the credit, realized when the underlying price => put strike.

If the underlying price increases above the short put: expires worthless, and the seller can keep the premium.

Theoretical Risk/Risk Profile

As the stock price falls, the naked put moves into loss more and more quickly, particularly when the stock price is lower than the strike price.

The maximum risk is the strike price of the put -/- ‘net credit/premium’) if the underlying price decreases below the short put. Since the strike price can go to $0, this can be considered an unlimited risk.

Naked short put losses are proportionate to the decreases in the underlying price and require a strict adherence to risk management rules due to the theoretical risk to the downside.

Breakeven

Underlying put strike -/- net put premium/credit.

Managing and Closing Position

Halfway to/Near Expiration

If the underlying price is above the short put, the short put expires worthless with the credit as profit. If the underlying price decreases below the short put strike, there is assignment risk.

Rules for Managing/Adjusting Position

• If the underlying increases above breakeven, the seller will profit.
• To adjust a tested/breached short put strike and extend the duration of the position, roll the short put down (to the around the 30 Δ put strike down AND out in time for a credit.
• Set alerts on breakeven/predetermined targets.

Rules for Closing Position/Exiting the Trade

• Manage by taking profits at:
  • 20%: 2d
  • 40%: 7d
  • 50%: 14d
  • 70%: 26d
  • 90%: 38s
• Profitable positions are closed by buying the option (BTC) to close following your trading rules for the target profit % of the net premium/credit received to open the position.
• Buy the short put option before expiration, ideally not later than 21 DTE.
• Close when significantly losing value: positions going against you (and below the stop loss you have set) are closed by buying the option (BTC) to close for a higher price than the net premium/debit paid to open the position.
• Alternatively, if the underlying is trading below the strike, and you want to take ownership of the shares at a cheaper strike price (since you obtained a premium when selling the put), you can let the shares be assigned to you at or before expiry.
• Manage multiple short puts by closing a portion of the position for profit, keeping some in place.
• Roll ITM when going to OTM when you still have a lot of extra value to roll into
• If underlying going down: rolling down and out to maintain extra value giving up breakeven, taking off intrinsic value
• Roll at credit or small debit.

Mitigating a loss

• Work with a (mental) stop loss based on an underlying asset of either 50% or 100% of the premium paid; if the underlying falls below the stop loss, exit by selling the calls.

Additional Notes

Advantages

• Gaining a regular income from rising or rangebound stocks.
• Cheaper than buying the stock (if exercised, you must buy the stock at a lower price, and you already received a premium).

Disadvantages

• Exposure to unlimited risk if the stock falls (up to $0).
• Even if you love to own the stocks, getting assigned to a falling stock.

Exercise/Assignment

Short puts can be assigned when the stock falls. Assignment means ownership of 100 shares of the underlying at the strike price.

A consideration every trader must make before entering the short put position is how the purchase of the stock will be financed in the event the put is assigned. You may have to buy the stock if you are assigned. Therefore, only sell puts Out-of-Money (OTM) on stocks you’d love to own at the strike price! But look for strong support areas to position our strike!