Knowledge Base

What is a Short Put Strategy?

in Trading Strategies
Tags: short puttrading strategy

Ever hear the adage ‘sold a lemon’? It is used to describe a situation where one gets sold something worthless in the garb of something of very high value. A Short Put strategy is an Options market strategy which, if used properly, does something similar. However, unlike selling ‘lemons’ it is perfectly fair and legal. Here is how it works:

What is a Short Put strategy

A Short Put strategy involves the sale (shorting) of a Put Option on an asset, with the intention of profiting from its appreciation in future, without having to buy the asset outright. A Put Option is a contract that grants its buyer the prerogative of selling an asset at a fixed price on a future date, without imposing on him an obligation to this effect. By using a Short Put strategy, the investor sells this prerogative to a buyer in exchange for a small price, called premium.

How to use Short Put strategy

The Short Put strategy is used by an investor who expects the underlying asset (such as a stock, index, currency or commodity) to appreciate from its current price. The objective of the strategy is to earn the premium by selling to the Option buyer, an Option that he will find unprofitable to use. By buying the Put Option, the Option buyer is essentially buying the privilege of selling the underlying asset at its current price, on a future date. Since the price is expected to rise from current levels, he will make a loss by using the Option. This would prevent him from using it. The seller of the Option, meanwhile, has already earned the premium through the sale of the Option.

Example of a Short Put strategy

Let’s consider an example to understand the strategy better.

Assume that a stock is currently trading at Rs 50 and is expected to appreciate. An investor would try to benefit from this by shorting a Put Option on 100 shares of the stock, with a strike price of Rs 50 and a three month expiry. For this, he would receive a premium of say Rs 3 per share, a total of Rs 300. The buyer of the Option now has the right to sell these 100 shares back to the Option seller at Rs 50 a share after three month. If the stock appreciates to say Rs 65, the Option buyer will incur a loss by using the Option, as it would mean selling the shares at a lower price of Rs 50 compared to the current price of Rs 65. Therefore, he will not use the Option. The seller of the Option will, however, make a profit of Rs 300, having received it as premium on the sale of the Option.

Payoff of the Short Put when the asset depreciates

If the asset depreciates to say Rs 40, instead of appreciating, the Option buyer will stand to benefit. Through the Option, he will be able to sell the shares at the original price of Rs 50, instead of the new, lower price of Rs 40. For the seller, this will mean a loss of Rs 10 per share amounting to a total loss of Rs 1000. Factoring in the premium of Rs 300, he would make a net loss of Rs 700. The loss increases as the asset’s price decreases. If the asset were to depreciate to Rs 30 instead, the loss would have been greater.

Benefits of a Short Put strategy

The advantage of using a Short Put is that it does not necessitate the purchase of the physical asset to benefit from its price appreciation. A Put Option can be bought for a miniscule premium, whereas the purchase of the asset entails the payment of its full price.