The Short Put option is a bullish strategy and a great way to get into options trading. Instead of buying a call you sell a put.
You set it up by sending a sell order for 1 put options contract at your chosen strike. These are the scenarios suitable for a Short Put:
- You want to collect the options premium
- You want to buy the stock but you think it’s expensive so you sell a put to purchase it if your price target is met
The strategy has a limited payoff and an undefined risk. The maximum loss will be realised if the company goes bankrupt. It follows that ETFs are less risky than individual stock.
You may think ‘why not buy a call instead, it’s limited risk and unlimited profit’. It’s because you have two chances to win: the stock goes up or it trades flat. There’s more but we’ll get into that in a bit.
Short Put Option Delta
As usual there are no hard rules but if you are selling 5 Delta options you are exposed to substantial risk for little premium.
Remember that you have undefined risk. You’ll lose $5,000 should the theoretical company in the example above go bankrupt. Therefore, 16 Delta or more is desirable.
The choice of Delta depends on how bullish you are. You can sell the at the money put if you have a strong conviction of a potential up-move or a 20 Delta if you want to give yourself some space to be wrong.
It is recommended to sell puts when the Implied Volatility rank is high because you’ll collect more premium and you’ll benefit from more time decay. This improves your breakeven too in the event that your strike is breached.
A long put has a negative Delta, therefore, your Short Put option has positive Delta ( -1 contract x (-20 Delta) = + 20 Delta).
The Delta will decrease when the share price goes up. Your P&L will be in the green.
However, an increase in the Delta means that the stock is moving against you and your P&L may end up in the red.
There’s no such thing as perfect timing and then we have to consider that the stock fluctuates. Inevitably a position will move against you.
Whenever you sell any option, call or put, you are short Gamma. Therefore, it will compound losses if the underlying stock tanks.
This happens because the Delta of the option is positive and will increase more and more with each $1 drop in the share price. The person who bought the put from you will observe a Delta which becomes more negative and Gamma which becomes more positive.
For example, we have two 20 Delta options in different stocks. One of them has 3 Gamma while the other has 30. A $1 decrease in the share price will increase the short put’s Delta to 23 and 50 respectively.
Gamma increases around 3 weeks prior to expiration and becomes the main loss factor. High Gamma means that a smaller move in the share price will cause greater increase in the Delta. Here is a visual of the Gamma increase:
This is easily managed by closing the position around 20 days prior to expiration.
You may find some options trading resources which claim that you should never be short Gamma in first place. I absolutely disagree! Do you tell a chess player to avoid using certain pieces?
One of the amazing advantages of options is the selection of strategies. You can achieve anything you want. I agree that it is important to trade in a safe manner but it doesn’t mean you should deliberately reduce your arsenal.
Short put options go hand in hand with a high IV rank. It’s one of the reasons to choose a Short Put over a Long Call. The call is too expensive so you sell a put instead. A low IV rank will result in inadequate premium to substantiate the risk.
The downside is that you are short Vega. So whenever you sell a put you make a stand that the implied volatility is overstated and you anticipate a decrease.
This will lead to a Delta and Vega driven profit if both the stock and volatility comply. In the mean time you benefit from time decay.
By equal measure the share price can decrease and you’ll incur Delta and Vega driven loss because IV normally increases when the share price decreases. This is sometimes referred to as ‘double whammy’ and we’ll discuss that more with regard to the short strangle.
And then you’ve got Vanna, a second-order derivative, which adds insult to injury. It’s the Delta-Vega relationship which will cause your Delta to swell further. So we end up with increased Delta because of the down-move and then a Vega and Vanna loss.
The easiest way to explain this is by thinking what happens when volatility expands. You’ll anticipate a wider range in the stock’s expected move. Thus, your put will have a higher chance of ending in the money since the price action is already going against your position.
You can see that the ‘double whammy’ is in reality a ‘triple whammy’.
Volatility expands quickly so you’ll be hurt less if it was already high when you sold the put.
I think that sometimes people don’t take Vega seriously enough so here’s an example. You sold a put with a Vega of 5. It doesn’t sound that much right? Maybe but you’re looking at a paper loss of $75 if the implied volatility goes up by 15%. That’s before taking into consideration Delta and Vanna.
Unlike the long call time decay is one of the Short Put’s best friends. Even if nothing else changes after you sell a put Theta will add a small bit to your P&L every single day, more or less.
You just sit there and wait until you collect your premium. That’s another reason to aim for high IV rank, it means high Theta, the more the merrier. The price of the option will be higher so inevitably it has to lose more money to time decay should everything else remain equal.
Similar to Delta and Vega Theta has higher-order derivatives too and this time all of them work in your favour.
The second-order ones, Charm and DvegaDtime, gradually annihilate your Delta and Vega exposure respectively. You only need to wait for the magic to happen.
Your Gamma will bleed too since it’s a derivative of Delta. I know that it sounds counterintuitive since I said that Gamma increases prior to expiration. How can an athlete run faster with a bleeding leg?
Let’s say you have a 30 day 5 Delta option with 1 Gamma. If you go to the 16 day expiration you’ll notice that the same strike has 2 Delta and 1 Gamma while the 5 Delta has 2 Gamma.
So the Gamma has doubled but the odds of the option ending in the money are pretty slim. It doesn’t matter because you’ll be closing the position prior to the Gamma increase. There’s no point in maintaining such a risk exposure over $0.20 worth of premium. You can trade something else, make your money work for you.
You need to be aware that Theta is a theoretical construct and the time decay won’t occur in a linear fashion. It all depends on the market conditions.
Short Put Option Management
Again, there are no hard rules. You can do anything you want. Here are the main approaches to management:
Close the position at 50% of max profit or any other arbitrary amount, like 70% or 30%. The logic behind this is fairly simple.
Imagine a $1.20 put with 40 days to expiration. If it goes down to $0.80 in 3 days you’ve made over 10% of the max profit per day. You can close it and trade something different rather than wait another 37 days for the remaining 70%.
This reduces the exposure and mitigates some of the risk of a crash.
What if you actually want the stock? Then you can wait a bit longer for a higher profit target or sell the next cycle.
You can’t sell options without getting used to the fact that you’ll see red in your P&L at one point or another. So when you do don’t freak out, check what’s going on.
If the IV has gone up and the share price is nowhere near your strike you just wait. It may cool off in a few days and everything will go back to normal.
Another scenario is when the share price declines. The two intervention points would be if your strike or breakeven is breached.
You can either wait a bit if you think that the stock will recover or roll the option to the next expiration cycle. If you’re rolling make sure that you collect additional premium.
Beware that whenever you roll a losing position you lock in a loss. You are closing one trade at a loss and opening a brand new one. So you need to be certain that this is your best option.
The last approach is to leave it alone. This is most suitable if you wanted to buy the stock in first place. However, even if you didn’t you can still take assignment and then sell covered calls against it. I know this is obvious but make sure you have enough money in your account to hold the stock.
I think that it is good practice to have a management plan before you send the sell order. The less you leave to chance the better.