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By selling a put option, you will receive the options premium in the form of a creditSHORT PUT A short put strategy offers limited profit potential and limited, yet high risk. It is best placed in a bullish market when you anticipate a rise in the price of the underlying market beyond the breakeven. By selling a put option, you will receive the options premium in the form of a credit into your trading account. The premium received is the maximum reward for a short put position. In most cases, you are anticipating that the short put will expire worthless. If you want to go short a put, your risk curve would look like the graph in Figure 4.16. A short put strategy creates a risk profile that slants downward from right to left from the limited profit. Notice that as the price of the asset falls, the loss on the short put position increases (until the price of the underlying stock hits zero). Additionally, the profit is limited to the initial credit received for selling the put. When the underlying instruments price rises, you make money; when it falls, you lose money. This strategy provides limited profit potential with limited risk (as the underlying can only fall to zero). It is often used to get high leverage on an underlying security that you expect to increase in price. As explained earlier, when you sell options, you will initially receive the premium for which you sold the option in the form of a credit into your account. The premium received is the maximum reward. The maximum loss is limited to the downside until the underlying asset reaches zero. What kind of a view of the market would you have to sell puts? You would have a bullish or neutral view. The breakeven for initiating the trade is the strike price at which the puts are sold minus the premium received. If the market were to rise, the position would increase in value to the amount of premium taken in for the puts. Looking at the risk graph, notice that as the price of the asset falls, the loss of your short put position increases (see Figure 4.16). This strategy requires a heavy margin deposit to place and is best placed using short-term options with high implied volatility, or in combination with other options. Short Put Mechanics Lets create an example by going short 1 January XYZ 50 Put @ 5. The maximum profit on this trade is equal to the amount received from the option premium, or $500 (5 100 = $500) minus commissions. To calculate the breakeven on this position, subtract the premium received from the put strike price. In this case, the breakeven is 45 (50 - 5 = 45). If XYZ rises above $45, the trade makes money. You earn the premium with the passage of time as the short option loses value. A short put strategy creates a risk profile that slants downward from right to left (see Figure 4.16). Notice that as the price of the asset falls, the loss of your short put position increases until the price of the underlying stock hits zero. This signifies that the profit increases as the market price of the underlying rises. Exiting the Position A short put strategy offers three distinct exit scenarios. Each scenario primarily depends on the movement of the underlying shares. XYZ rises above the put strike price (50): This is the best exit strategy. The put expires worthless and you get to keep the premium, which is the maximum profit on a short put position. XYZ reverses and starts to fall toward the breakeven (45): You may want to offset the position by purchasing a put option with the same strike price and expiration to exit the trade. XYZ falls below the put strike price (50): The short put is as signed and the put writer is obligated to buy 100 shares of XYZ at $50 per share from the put holder. The short put seller now has a long shares position and can either sell the XYZ shares at a loss or wait for a reversal. The maximum loss occurs if the price of XYZ falls to zero. The short put writer then loses $5,000 (100 shares 50 = $5,000) less the $500 credit received from the premium, or a total loss of $4,500 (5,000 - 500 = $4,500). Short Put Case Study When we buy a put, we want the underlying security to move lower. Thus, when we sell a put, we want the stock to rise. However, our maximum Short Put Strategy: Sell a put option. Market Opportunity: Look for a bullish or stable market where a rise above the breakeven is anticipated. Maximum Risk: Limited as the stock price falls below the breakeven until reaching a price of zero. Maximum Profit: Limited to the credit received from the put premium. Breakeven: Put strike price - put premium. Margin: Required. Amount subject to brokers discretion. profit is the premium we receive for selling the put, so if we expect a large move higher in the stock, we would be better off to buy a call. Selling a put is best used when we expect a slightly higher price or consolidation to take place. When a stock falls sharply to support in one or two sessions, this is often a good time to look at selling puts. If we expect that the stock might start to consolidate following a decline, selling a put could provide nice profits. However, the risk remains rather high because the stock could continue to fall and a put seller is at risk the whole way down to zero. On July 31, 2003, shares of Cardinal Health (CAH) fell $10 to about $55 a share. This drop might have seemed overdone given the circumstances and a trader could have entered a short put near the close of the session. The August 55 put could be sold for $1.65, which means selling five contracts would bring in $825. We want to use the front month option because time value works in our favor. If CAH were to stay at $55 or move higher by August 15, the trader would receive the maximum profit. The risk graph shown in Figure 4.17 details how the risk in this trade is rather high compared with the reward. This means that margin will be an issue and that a large amount of margin will be needed to enter this type of trade. The breakeven point for this trade is calculated by subtracting the credit received from the strike price (55 - 1.65 = 53.35). Thus, even a slight move lower would still generate a profit in this trade, but if CAH were to fall below $53.35 the losses would start to grow. Fortunately, shares of CAH did move higher after this decline, leaving the trader with the maximum profit of $825 from the sale of five puts. Later, we will talk about a less risky way to profit using spreads instead of naked options. Strategy: With the stock trading at $54.75 a share on July 31, 2003, sell 5 August 55 puts @ 1.65 each on Cardinal Health (CAH). Market Opportunity: Expect CAH to consolidate or move higher following large one-day drop in shares. Maximum Risk: Unlimited as stock falls all the way to zero. Maximum Profit: Initial credit received. In this case, $825: (5 1.65) 100. Breakeven: Strike price minus the initial credit per put. In this case, 53.35: (55 - 1.65). Margin: Extensive. COVERED PUT You can also use a covered put in a bearish market to profit from a possible increase in a short stock or futures position. A covered put consists of selling the underlying futures or stock position and selling a put to cover the underlying assets position. This trade can be very risky, because it involves short selling a stock, which requires a high margin. The reward on a covered put is limited to the difference in the initial price of the short underlying asset minus the strike price of the short put plus the credit received for the option premium. Covered Put Mechanics In this example, lets go short 100 shares of XYZ @ 50 and short 1 June XYZ 45 Put @ 2.50. The risk graph below shows a covered put position at expiration. Once the market moves to the upside above the breakeven, there is unlimited risk. Margin is $7,500 (stock price plus 50 percent more); however, the credit on the short stock is $5,000. In addition, the credit on the short put is $250. Total credit is $5,250. The maximum reward on this trade occurs if XYZ closes at or below 45 at expiration. The maximum profit for this trade is $750: (50 - 45) + 2.50 100 = $750. Figure 4.18 shows the risk profile for the covered put example. As with most short strategies, this trade is hazardous because it comes with unlimited risk. The breakeven of a covered put strategy equals the price of the underlying asset at trade initiation plus the option premium. In this trade, the breakeven is 52.50: (50 + 2.50 = 52.50). That means that if XYZ moves above $52.50, the trade will lose $100 for each point it rises. In fact, the higher the underlying asset climbs, the more money will be lost (see Figure 4.18). Exiting the Position Since a covered put protects a stock only within a specific range, it is vital to monitor the daily price movement of the underlying stock. Lets investigate optimal exit strategies in the following scenarios: XYZ declines below the short strike price (45): The short put is assigned and you are obligated to buy 100 shares of XYZ from the option buyer at $45 per share. However, you can unload these shares for the short share price of $50. This exit process garners the maximum profit of $750. XYZ declines below the initial stock price (50), but remains above the short strike price (45): The short put expires worthless and you get to keep the premium received. No losses have occurred on the short stock position and you are ready to place another covered put to bring in additional profit on the position if you wish. XYZ rises above the initial stock price (50) but stays below the breakeven (52.50): The short stock position starts to lose money, but this loss is offset by the credit received from the short put. As long as the stock stays below the breakeven, the position will break even or make a small profit. XYZ rises above the breakeven (52.50): Let the short put expire worthless and use the credit received to partially hedge the loss on the short stock position. Both covered calls and covered puts are high-risk strategies, although they can be used to try to increase the profit on a trade. It is essential to be aware of the risks involved and to be extremely careful in selecting the underlying markets for your covered call or put writing strategies. Covered Put Case Study A covered put can be used to profit in the short term by going short a stock and then selling a put to bring in additional income. The reason a covered put is not a suggested strategy for most traders is because it has unlimited risk. The sale of the put does help offset the cost of the short Covered Put Strategy: Sell the underlying security and sell an OTM put option. Market Opportunity: Slightly bearish to neutral. Look for a market where you expect a decline or stability in price with little risk of the market rising. Maximum Risk: Unlimited as the price of the underlying increases to the upside above the breakeven. Maximum Profit: Limited to the credit received on the short put option + (price of security sold - put option strike price) 100. Breakeven: Price of underlying security at trade initiation + put premium received. Margin: Required. Amount subject to brokers discretion. stock, but if the stock rises, this income might mean very little. Lets use Rambus (RMBS) once again to show how a covered put would have worked for this stock when compared to a covered call. By entering a short put, we have limited risk to the downside all the way to zero. At the same time, we have unlimited risk to the upside and a large margin requirement for selling the stock short. Lets assume we didnt already own Rambus, so we need to sell short 500 shares at $30 and sell five December 30 puts. Remember, RMBS shares were trading right at $30 a share, so we would be able to keep the entire premium from the put if the stock closes at or above this point. However, as the stock declines, we profit from being short on Rambus. The December 30 puts could be sold for 2.10 each and Rambus shares could be sold short for $30 a share. Thus, we would receive a credit of $16,050 for entering the covered put. However, the maximum profit would be limited to just $1,050. The best way to see this is by looking at a risk graph of the trade shown in Figure 4.19. Notice how the risk continues to grow as the stock moves higher. This is because the amount of money brought in from selling the put does little to offset the potential loss obtained from selling RMBS shares short. However, no matter how low the stock moves, our maximum profit is achieved because the gain in the short stock will offset the loss in the short put. In our example, shares of RMBS did try several times to break higher, but each time resistance held and the stock ultimately closed at 26.37 on expiration (December 19). This would have resulted in the maximum profit of $1,050. The short put would have had a value of 3.70 to buy back on expiration. This results in a loss of 1.60 each (or $800 for five contracts) for the put. However, the 500 shares of RMBS sold short are now showing a profit of 3.63: (30 - 26.37). This means the profit from the short stock is $1,815: (3.63 500). If the option were not bought back, the trader would be forced to buy shares to cover the short, but the net result would still be a profit. This might seem like a good way to bring in premium on a stock expected to move lower. However, the margin required would be large and the risk is normally just too high to be a consistently profitable strategy. Covered Put Case Study Strategy: With the stock trading at $30 a share on December 1, sell 5 December 30 puts @ 2.10 each and sell short 500 shares of Rambus stock. Market Opportunity: Expect consolidation in shares after failure to break out. Maximum Risk: Unlimited to the upside above the breakeven. Maximum Profit: Limited to the credit received on the short put option + the price of security sold - put option strike price 100. In this case, the maximum profit is $1,050: (5 210) + (30 - 30) 100 = $1,050. Breakeven: Strike price + put option credit. In this case, 32.10: (30 + 2.10). Margin: Significant. |
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