What is Short Put?

Introduction

If you are familiar with derivatives in the stock markets, you may have come across options trading. Options trading involves contracts that give you the right, but not the obligation, to buy or sell an asset at a predetermined price within a specified time. This flexibility allows you to speculate on the future direction of the market or hedge against potential losses. 

There are various strategies that you can use in options trading, one of which is a Short Put. This strategy, often employed by traders to generate income, requires a solid understanding of market movements and risk management.

In this guide, you will learn about a Short Put in detail, explore how it works, its benefits, and the associated risks.

What is Short Put?

A Short Put, also known as selling a put option, is a strategy in options trading where you sell a put option contract. By doing this, you give the buyer the right, but not the obligation, to sell a specific amount of an underlying asset to you at a predetermined price (strike price) within a set period.

If the buyer decides to exercise this option, you are obligated to buy the asset at the strike price. You typically use this strategy when you expect the price of the underlying asset to remain above the strike price, making the put option worthless at expiration. Thus, the premium received from selling the put option becomes your profit.

How Short Put Works

When you sell a put option, you get a payment called a premium from the buyer right away. This premium is your profit if the option expires without being used, meaning the price of the underlying asset stays above the agreed-upon price (strike price). Here’s how it works step-by-step:

-Selling the Put Option: You sell a put option on an underlying asset. This means you agree to buy the asset at the strike price if the buyer wants to exercise the option.

-Collecting the Premium: You get a premium from the buyer as your initial profit.
Market Movement: The price of the underlying asset changes. If it stays above the strike price, the put option will probably expire worthless.

-Expiration: When the option expires, if the asset’s price is more than the strike price, the option is worthless, and you keep the premium. If the price is below the strike price, you may have to buy the asset at the strike price.

Example of a Short Put

Let’s say you enter into a short put or sell a put option on XYZ stock with a strike price of ₹100. The expiration date is one month from now and the premium is ₹5 per share for selling this option. By entering into this option, you are hoping that the stock price will remain above ₹100 until the option expires. Here are two possible scenarios:

-Stock Price Goes Above Strike Price: If XYZ stock is trading at ₹105 at expiration, the option expires worthless because the buyer won't sell you the stock at ₹100 when they can sell it for ₹105 in the market. You keep the ₹5 premium as profit.

-Stock Price Goes Below Strike Price: If XYZ stock is trading at ₹95 at expiration, the buyer exercises the option, meaning you are obligated to buy the stock at ₹100. However, considering you received a ₹5 premium, your effective purchase price is ₹95.

In both cases, the key point is that by selling the put option, you're hoping the stock price stays above ₹100. If it does, you make a profit from the premium you collected upfront. If it doesn’t, you might have to buy the stock, but the premium you received helps to reduce your effective purchase price.

Also Read: 3 Key Ways To Make Futures and Options Trading Profitable

Risks of Selling Puts

Short put means selling puts. This comes with certain risks that you need to be aware of:

-Considerable Downside Risk: In case the underlying asset’s price drops significantly, you could face considerable losses. You are required to buy the asset at the strike price, which could be much higher than the market price.

-Limited Profit Potential: The most profit you can make is the premium you receive when selling the option, no matter how high the asset price goes.

-Margin Requirements: Selling puts usually requires you to maintain sufficient funds in your trading account, known as margin, to cover any potential obligations. 

-Assignment Risk: If the option becomes profitable for the buyer, you might need to buy the underlying asset at any time before the expiration date.