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Short Put

The written put can provide the investor with extra income in flat to rising markets. It can also be used as a way to buy stock cheaply. This strategy is generally used when the investor expects the share price to remain steady or increase slightly over the life of the option.

When to use
Market outlook neutral to mildly bullish
Volatility outlook falling

Payoff diagram

short put payoff diagram

The short put
Construction short put X
Point of entry market around X, but can vary
Breakeven at expiry strike price less premium received
Maximum profit at expiry premium received
Maximum loss at expiry strike price less premium received
Time decay helps
Margins to be paid? yes
Synthetic equivalent long stock, short call X

Profits and lossesĀ 

The maximum profit the investor can make is the premium received for writing the option, which will occur if the share price at expiry is above the strike price. The investor breaks even if at expiry the share price is equal to the strike price of the option less the premium paid. As the share price falls beyond this point, the potential losses of the sold put are limited only by a fall in the share price to zero. If the investor does not close out an in-the-money put before expiry, the option will be exercised and the investor will be required to buy the underlying stock at the strike price of the option.

Other considerations

  • Cheap stock: many investors write put options as a way of buying stock cheaply. If the share price falls and the option is exercised, the purchase price is effectively the strike price of the option less the premium received - which is less then the price of the stock at the time of writing the option. If the share price at expiry is above the strike price, the option will expire worthless. The investor does not get to buy the stock, but has benefited from the receipt of the premium.
  • Time decay: time decay works in favour of the put writer. If the stock price stays steady, the at-the-money option will deliver the most profit to the put writer, as this is the option with the most time value.
  • Exercise: the put writer must be wary of early exercise. A put option is generally more likely than a call option to be exercised early.

Follow-up action

If at expiry the stock is trading below the strike price, the put writer will be exercised unless the position has been closed out. As expiry approaches, the investor should consider buying back the put if they do not want to own the stock.

Alternatively, the investor could roll the option position to a later month and possibly a different strike price.

Points to remember

  • This strategy can result in heavy losses if the share price falls significantly. Only write puts if you have the financial capacity to buy the underlying shares should you be exercised.
  • Monitor the position closely. You will need to close out an in-the-money option in order to avoid exercise.

Example

BIG Limited is trading at $5.00 at the start of March. You would be happy to buy the stock, but would ideally like to pay below the current price. You decide to sell an at-the-money put option. If the stock is below $5.00 at expiry, you will be exercised, and your effective purchase price for the stock will be $4.65 (the $5.00 strike price less the $0.35 received for writing the option). If the stock is above $5.00, the option will expire worthless, and you will have benefited from the option premium.

Sell 1 BIG May 500 Put @ $0.35.

short put payoff diagram

Disclaimer
The information contained in this webpage is for educational purposes only and does not constitute financial product advice. ASX does not represent or warrant that the information is complete or accurate. You should consider obtaining independent advice before making any financial decisions. To the extent permitted by law, no responsibility for any loss arising in any way (including by way of negligence) from anyone acting or refraining from acting as a result of this material is accepted by ASX.

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