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Options Trading: Short Puts, the Overlooked Strategy

Posted March 3, 2011

Topics: Finance & Investing

So many traders gravitate to the covered call. It is safe, profitable, and easy to understand. Uncovered calls, on the other hand, are high-risk and dangerous. But is the same true for uncovered puts? Perhaps not.

Shorting options is not limited to calls. It consists of covered or uncovered calls and uncovered puts. You cannot cover a put except with a more complex strategy of put spreading or synthetic positions. However, the uncovered put is not as risky as you might think.

The risk of a short put is not the difference between strike price and zero. Realistically, it is really the lowest likely price to which a stock’s price could fall. That is probably tangible book value per share. Remember, also, that a  put can only fall so far, whereas a call could rise indefinitely, in theory at least.

Three things to keep in mind about uncovered put risks:

1. Lower-priced stocks have less put risk. This is basic math. A $10 stock can fall only 10 points in the worst case, whereas a $60 stock could potentially fall six times farther. So limiting short put plays to lower-priced stocks lowers your worst-case risk. Of course, premium is lower as well, but that is the trade-off for lowering your market risk.

2. The premium you are paid for selling the put discounts risk. If you are paid 2 ($200) for selling a put, your breakeven is two points below the put’s strike price. This gives you the chance to close out the position to avoid exercise.

3. You can roll the put forward to defer or avoid exercise. When you cancel one put by buying to close, you replace it with a later-expiring short put, meaning you also get more cash. The most likely exercise date is the last trading day before expiration, so you have plenty of time if you act early, and roll as the put approaches the money instead of after it goes in the money. You can also roll forward and down to lower the strike. This take you farther away from the money.

Keep your plans realistic. Don’t sell a put unless you consider the strike to be a good price for the stock. You could get exercised at any time, and you should be willing to buy those 100 shares at the strike price. The cost of stock in the event of exercise is the strike price minus the premium you received. For example, if the strike is 15 and you sell a put for 2, your net cost is $13 per share.

If your put is exercised, you can keep the stock and sell covered calls against it, or just wait for the price to rebound so that you can sell later at a profit. The uncovered put is not the high-risk strategy equally risky with the uncovered call. It works best when the stock’s price is trading sideways or increasing.

Michael C. Thomsett is an instructor with the New York Institute of Finance. He teaches three options courses: “Swing Trading with Options,” “The Amazing World of Options,” and “Synthetic Options Strategies.” He is also an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Trading with Candlesticks. He also contributes to the CBOE newly-formed blog.