Français FR
laptop and phone image

Lesson 5:

Understanding Sold

(Short) Puts

A short put is the other side of a long put. Now let's turn our attention to the short put writer/seller.

Lesson 5: Understanding Sold (Short) Puts

Understanding Sold (Short) Puts

short put

Short puts are sold to open

Let’s break down a short put. Short means sold and put means contains the right to sell. To create a short put, the trader sells to open the put and receives a premium in the form of a credit. Sold contracts are intended to contain as little value as possible.

Maximum loss is substantial

Only option buyers can execute upon the terms of the contract, the short put holder is obligated to fulfil those terms. This means that long puts are exercisable, and short puts are assigned. In this example, the short put holder sold the right to sell ABC at $100 at any time through the expiration date. If the buyer chooses to execute upon this contract, the short put holder is obligated to purchase 100 shares of ABC at the $100 strike price. In simpler terms, it’s the buyer’s decision, they decide when they would like to sell the shares if at all. If they decide to sell the shares at the strike, the short put holder purchases the shares from them at that strike price. The short put holder receives a premium (options price) for the contract. As ABC can decrease to zero, this means that the short put holder may have to purchase ABC at the higher strike price to fulfil their obligation and sell the shares at a considerably lower strike. This is how the short put writer faces substantial loss potential.

Lesson 5: Understanding Sold (Short) Puts

Understanding Sold (Short) Puts

short put

Short puts have limited profit potential

When selling an option contract, the contract seller wants the option to deplete in value and recognizes maximum gain when the option is completely worthless. The long put holder owns the right to sell at the $100 per share strike price. Therefore, for this contract to not contain any value, ABC stock needs to be greater than the $100 strike price. If ABC remains above the strike, this means that it is more favorable to sell the stock on the market than execute upon the terms of the contract. The short put writer will be able to purchase the contract back at a lower price or keep the entire premium if held until expiration day when ABC is trading above the strike.

Time is working for short options

Options that contain longer expiration dates are more expensive as there is more time for the options position to rise in value. As the option nears expiration, the time value component of the options premium will deplete. When selling options, the time decay depletion of the premium is beneficial. ABC can remain at or above the strike making the short put profitable. Thus, a short put profits in a neutral or bullish environment. As the options premium depletes in value, the option seller can buy to close the short put at a lower price or choose to hold it until expiry.

Lesson 5: Understanding Sold (Short) Puts

Short Put

Profit/Loss at Expiration

profit and loss

This option is out-of-the-money or does not contain any executable/intrinsic value when the underlying position (ABC) is trading above the $100 strike price. This is because the put contains the right to sell 100 shares of ABC at $100. Therefore, if ABC is trading at $100.01 or higher the option does not contain executable value as selling at the strike is less advantageous than the market price. Any option that is out-of-the-money only contains extrinsic value which will deplete as the option nears expiration. If ABC continues to trade above the $100 put strike at expiration, the put option will not have any intrinsic or extrinsic value and will simply expire worthless. Therefore, a short put option profits from a neutral to upward movement in the underlying and as the option nears expiration, time value depletes from the premium.

Lesson 5: Understanding Sold (Short) Puts

Key Takeaways

checklist

1. A short put option is a sold option that contains the right to sell. The put seller is obligated to purchase 100 shares of the underlying asset at the strike price executable at any time by the long put holder through the expiration date. The contract is sold for a premium, the short option holder wants the option to not contain any value to keep the premium.

2. To create a short put option, the investor will sell to open the put. The value of the put option will change during the lifetime of the contract and, at any time, can be bought to close or can be held until expiry to be assigned or expire worthless. This generates either a profit or a loss on the trade.

3. A short put is neutral to bullish and profits if the underlying remains at or above the strike price. As the underlying position can decrease to zero requiring the seller to fulfill the terms of the contract, the strategy contains substantial loss potential.

4. All else equal, time works for this strategy. This is because the extrinsic value of an option will depreciate to $0 by expiration and in doing so, will reduce the overall premium of an option allowing the short put holder to purchase the put to close at a lower price.

Click “NEXT” to check your knowledge

laptop and phone image

Lesson 5:

Knowledge Check

Lesson 5: Understanding Sold (Short) Puts

Knowledge Check

Lightbulb logo

What is the maximum loss potential for a trader who has sold a short put option?

(Select an answer below)

Lesson 5: Understanding Sold (Short) Puts

Knowledge Check

Lightbulb logo

Under what condition does a short put writer realize their maximum profit?

(Select an answer below)

Lesson 5: Understanding Sold (Short) Puts

Knowledge Check

Lightbulb logo

How does time decay benefit the seller of a short put option?

(Select an answer below)

laptop and phone image

Congratulations!

You have completed The Framework - Lesson 5:

Understanding Sold (Short) Puts

CONTINUE TO NEXT LESSON

“BMO (M-bar Roundel symbol)” is a registered trademark of Bank of Montreal, used under licence. BMO InvestorLine Inc. is a wholly owned subsidiary of Bank of Montreal. Member – Canadian Investor protection Fund and Member of the Canadian Investment Regulatory Organization.