Short Put Option: Profit Calculator and Payoff Visualizer

What is a Short Put Option?

The short put option is a bullish to neutral options trading strategy that involves selling (writing) a single put option. If assigned, the put seller must be prepared to purchase the underlying asset from the buyer, resulting in stock ownership.

The short put is a high-risk, limited-reward trade typically used by bullish or neutral traders. A short put is generally profitable when the underlying price:

• Remains the same
• Moves higher

You also want implied volatility (IV) to stay the same or decline for a short put to be profitable. A small jump in IV can cause option prices to soar, which can lead to mounting losses for short calls and puts.

The premium collected from the short put acts as a buffer against minor underlying/stock price drops.

Naked Short Put

When you sell a put option without holding any other option position in the underlying asset, it’s called a naked short put. Naked short puts carry significant risk because, in theory, the stock price can drop to zero.

For example, if you sell a 99 strike price put option for $0.50 on a stock trading at $100 per share, your maximum gain is the premium collected ($50, or $0.50 × 100 shares), while your maximum loss is $9,850. This maximum loss assumes the stock drops to zero. While such an extreme scenario is rare, sudden spikes in market volatility can cause losses to escalate quickly.

To reduce this risk, many traders sell a put option with a lower option's strike price, creating a vertical spread, also called a bull put spread. This approach limits risk and significantly lowers the margin requirements compared to a naked short put.

Short Put: Payoff Diagram and Calculations

The short put calculator included at the beginning of this article will display interactive payoff diagrams, making it easier to visualize potential outcomes for any underlying asset. 

Here are the straightforward payoff calculations for the short put options trading strategy:

Max Profit

• Formula: Premium received
• Explanation: The profit is capped at the premium collected when the underlying price stays at or above the option's strike price at expiration.

Max Loss

• Formula: (Strike price - premium received) * 100.
• Explanation: Losses can be significant, with the maximum loss occurring if the underlying price falls to zero.

Breakeven Point

• Formula: Strike price - premium received‍
• Explanation: Losses begin if the underlying price drops below the breakeven point, calculated as the option's strike price minus the premium collected.

Short Put Option: Moneyness

Understanding the concept of an option's moneyness is key to knowing when short put options are profitable. The moneyness state directly impacts a put's profit profile.

Out-of-the-Money (OTM)

Out-of-the-money (OTM) short put options are comprised completely of extrinsic value. They have a strike price lower than the current stock price. These options are slightly bullish to market neutral, as the underlying price must remain above the strike price to avoid moving in the money and causing potential losses.

Selling OTM puts offers a smaller option premium but have a greater chance expiring worthless.

At-the-Money (ATM)

At-the-money (ATM) short put options have a strike price equal to the underlying asset's current price. These options are moderately bullish and are suited for traders expecting minimal downward movement or a slight increase in the underlying price.

Since ATM options have no intrinsic value, their entire premium is comprised of extrinsic value.

In-the-Money (ITM)

In-the-money (ITM) short put options have a strike price higher than the current stock price. These highly bullish options require the underlying asset price to rise significantly above the strike price to expire worthless and maximize profitability.

Selling ITM short puts can be profitable for traders expecting a substantial price rise.

Short Put and Time Decay

Most traders understand that buying single options, particularly out-of-the-money (OTM) options, is typically a losing strategy over the long term. This is largely due to time decay, also known as "theta."

ATM and OTM options derive their price entirely from extrinsic value because they have no intrinsic value.

Extrinsic value is heavily influenced by theta. As time passes without significant movement in the underlying asset price, the likelihood of an ATM or OTM option expiring ITM decreases. This decline in probability leads to a steady erosion of the option's price

For this reason, most professional traders prefer selling options rather than buying them. However, selling options naked carries significant risk, especially when the underlying price moves sharply against the position, which can result in substantial losses.

Short Put Options: Assignment Risk

Option sellers need to be aware of assignment risk when shorting puts.

Put options give the buyer the right, but not the obligation, to sell the underlying asset at the option's strike price. The seller must purchase the underlying asset if a put option is exercised. The likelihood of a short put option being exercised increases under the following conditions:

• The option is in-the-money (ITM), with a higher probability the deeper ITM it is.
• The expiration date is near, as reduced time increases intrinsic value.
• The option's value is primarily intrinsic value.

Short option sellers can reduce assignment risk by trading European-style options, which, unlike American-style options, can only be exercised at expiration. Let’s compare these two types of options next!

Types of Options Contracts

There are two different types of option contracts: American-style and European-style.

American Style Options

Most stock and ETF options are American-style, meaning they allow for early exercise. This flexibility exists because these options are tied to tradable underlying securities, like stocks or ETFs.

European Style Options

Most index options are European-style, meaning they can only be exercised at expiration. This structure is common for indices like SPX (S&P 500 Index) and NDX (Nasdaq-100 Index), which do not have an underlying tradable security.

Because these options are cash-settled, early exercise would provide no benefit. Instead, the final settlement value is determined at expiration based on the index level at that time.

Short Puts and Margin Requirements

Selling options naked requires a significant margin, so it's crucial to consider the opportunity cost of your trade. 

For example, if you sell a put option on a $500 stock for a $0.35 premium with 5 months until expiration, and the trade requires $6,000 in margin, it’s worth considering: what could you have earned by investing that $6,000 in T-bills at the risk-free rate instead?

Margin requirements differ by broker, but generally speaking, the margin requirement for short puts is the greater of:

1. 20% of the underlying price minus the out-of-the-money amount, plus the premium received, or
   
2. 10% of the underlying price plus the premium received

Short Put: Real World Trade Example

Let’s say you are bullish to neutral on SPY (SPDR S&P 500 ETF Trust) and expect it to stay above 600 over the next seven days.

You pull up an options chain and sell the 600 strike price OTM put option on SPY for $1.43, as seen on the TradingBlock trading platform below.

Initial Trade Details:

• Symbol: SPY
• Underlying Price: $604.52
• Strike Price: 600
• Option Price (Credit Received): $1.43 ($143 total)
• Days to Expiration (DTE): 7 days
• Net Margin Requirement: $12,000

Four days have passed, and SPY has made a slight downward move to $604.00, still above the strike price.

What happened to our short put?

• Symbol: SPY
• Underlying Price: $604.52 → $604.00 (-$0.52)
• Strike Price: 600 (unchanged)
• Option Price: $1.43 → $0.85
• Days to Expiration (DTE): 7 days → 3 days

Trade result:

The option premium has dropped from $1.43 to $0.85. As the seller, you can now buy back the option at $0.85, locking in a profit of $0.58 per contract ($58 total).

Why did this happen?

The small price decrease in SPY was not enough to make the option move significantly closer to being ITM. Additionally, time decay (theta) reduced the option's extrinsic value as expiration approached, working in your favor as the seller. Here’s how theta ate away at the price of the option over the days:

Short Puts: Delta and Gamma

Short puts are influenced by the Greeks delta and gamma, which measure price sensitivity and acceleration of change.

Delta: Represents the rate of change in the option's price for every $1 change in the underlying asset.

• Short puts have a negative delta, meaning they lose value as the underlying price decreases and gain value as the price increases.

Gamma: Measures the rate of change in Delta.

• Short puts have negative gamma, meaning the position's delta becomes increasingly negative as the price falls. This causes losses to accelerate during sharp downward price moves since each additional dollar drop has a larger negative impact than the previous one.

Explore Options With Virtual Trading

With TradingBlock’s virtual trading platform, you can trade options in a simulated environment. Check it out below today!

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⚠️ When selling short puts, risk management is crucial. Beyond the premium received, remember to account for commissions and fees, as they can significantly affect your net profit or loss. These costs should always be factored into your trading strategy. Please read Characteristics and Risks of Standardized Options before trading options.