Short Put (Naked put/ uncovered put)

The Short Put Setup

Suppose you think that a company called SteadyRise, which is currently trading for $50 a share, will never significantly fall, owing to its strong financials and market position. You would write a naked put option with a strike price of $45 which, naturally, expires in three months. You would receive $3 as a premium for each option.

Who will use this Option

The short position will be suitable for someone who is neutral to bullish toward the asset and who has no issue taking the underlying stock as long as it trades below that particular strike price. The participants of this strategy intend to derive income from the premium with the assumption that they’d be willing to fulfill their obligation to purchase the underlying stock.

How the Strategy Works

When you sell behind naked puts, you obligate yourself to buy the underlying asset at the strike price if the buyer of the put decides to exercise his option. This occurs when the asset’s price closes under the strike price before or by expiration. The option expires worthless if the price of the asset stays above the strike, and you keep the premium collected as your profit.

Breaking Even

The break-even point is derived by deducting the premium received from that of the strike price. In the above example, the breakeven would amount to $45 (strike price) -$3 (premium received) = $42. Thus the asset has to stay above $42 in order for you not to end up on the losing side by expiration.

Sweet Spot

This strategy is activated when the underlying asset stays well above the strike price, leading to the expiration of the put option as worthless and the retainment of the complete premium sum.

Max Profit Potential

Highest profit will be limited to the premium received for selling the put option; in this case, $3 per share.

Max Loss

Maximum loss if the underlying asset were to become worthless would take place because you would be obliged to buy a worthless asset at the strike price. Therefore, at worst, you may lose the strike price minus the premium received, which in this case is $(45 -3 = 42) per share.

Risk

It is a high-risk strategy-firstly because upon selling the put, if the price of the asset drops below the strike price, you may be bound to buy a much more expensive underlying asset than its market price. This risk is similar to owning the stock, with the additional potential of premium income coming your way should the put expire worthless.

Time Decay

This is a favorable factor towards time decay of the short put strategy. Because upon approaching expiration, if the stock price is above the strike price, the value of options will tend to fall, thus resulting in an enhanced chance of being able to keep some premium revenue.

Implied Volatility

Diminished implied volatility will work to the strategy’s favor once the put is sold, as it should reduce the number of chances that by expiration the option really closes in-the-money. Then the risk becomes that of having to buy the stock at the predetermined strike price under the conditions of heightened volatility.

Conclusion

The short put option strategy can yield some sort of value-added income if one believes that the asset price is unlikely to decline radically. The scope of unlimited risks ensuing from a fall on the part of the underlying asset leads to the need for paying utmost attention to risk management. They are used by informed investors who have the means to change their strike price and exercise in the most improbable event that a sale continues to register losses.