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Options Trading: The Value of the Short Put

By  Jan 28, 2010

Topics: Finance & Investing

The covered call is probably the best-known and favorite of all options strategies. Of course. It is safe and profitable, yielding double digit returns if done right. But the uncovered put should not be ignored in the world of shorts … it can also play a part in your portfolio.

The “world of shorts” as I like to call it is not a reference to the underwear department at Sears. It consists of covered or uncovered calls and uncovered puts. (You cannot truly “cover” a put except with a more complex strategy of put spreading.) For now, I want to focus on the fact that naked puts are not as risky as some people believe.

The true risk of a put is not the difference between strike price and zero. It is actually the lowest likely price to which a stock’s price could fall. That is more likely to be tangible book value per share. Three factors make the short put far less risky than it appears at first.

1. Lower-priced stocks represent lower short put risk. This is basic math. A $20 stock can fall only 20 points, whereas an $80 stock could potentially fall four times farther. So simply limiting short put plays to lower-priced stocks lowers your worst-case risk.

2. The premium you get for selling the put discounts your risk. If you get 3 ($300) for selling a put, your breakeven is three points below strike. This “safety net” gives you the chance to close out the position without risking exercise, and still make a profit. Remember, three out of all four options expire worthless, so your true exercise risk is quite low.

3. You can roll forward to defer or avoid exercise altogether. When you close out one position and replace it with a later-expiring one, you get more cash, and you greatly reduce the chance of exercise. The most likely exercise date is the last trading day before expiration, so knowing this date is approaching gives you plenty of time. If the put is in the money, you can also roll forward and down to lower the strike.

A good basic rule to live by is this: Never sell a put unless you consider the strike to be a good price for the stock. The chance that you could get exercised means you should be willing to live with that if and when it occurs. The true cost of stock in the event of exercise is going to be the strike price minus the premium you get. For example, if the strike is 25 and you sell a put for 3, your true cost is going to be $22 per share.

After selling the put, you can keep the stock and sell covered calls, or just wait for the price to rebound so that you can sell later at a profit. The point to remember is that the uncovered put is not the high-risk class of strategy equal in risk to the uncovered call. It is actually a more attractive strategy that works best when the stock’s price is trading sideways or declining.