Short Put Option Strategy: Basics, Example, and Defense | tradeTALK Series
Apr 5, 2021
The short put strategy is an effective way to acquire 100 shares of stock at a lower cost basis than the market is offering right now. You can be profitable if the stock stays the same, goes up, or even goes down a little bit, which is why it’s such a high probability trade. But what happens if the stock goes down dramatically? How can we reduce our max loss, improve our probability of success, improve our max profit and give ourselves more time to be right on our directional assumption? Mike Butler covers it all in his tradeTALK on Short Puts and here, too!
In this post, we’ll take a look at:
Options Pricing: Intrinsic & Extrinsic Value
Short Put Strategy Basics
Strike Price & Expiration Choices
Short Put Defense: Rolling a Short Put
Let’s dig in!
In the world of options trading, we can either buy an option and pay a debit to own the contract, or sell (short) an option and collect a credit for assuming the risk of the short contract. For put contracts, that risk is “being put” 100 shares of long stock at the strike price, if the stock were to be below the strike at expiration.
Long puts are typically used to speculate on a stock selling off, or to protect 100 shares of stock that an investor may own, below the strike price chosen. When we buy a put option, we are betting for the bearish movement of the stock price, and we need it to move down significantly to be profitable at expiration. We pay a debit for the right to own this contract, and the debit paid is our risk in the trade if we are wrong about our assumption.
This typically results in a low probability trade if we hold the option to the contract’s expiration, because we need the stock price to move down significantly to be profitable, since we must offset the initial cost of the contract itself upfront, and then some.
Selling a put is the complete opposite in every way.
If we sell a put instead, and assume the risk of 100 shares of long stock below the strike price, we have undefined risk (capped at the stock reaching $0.00), and a limited amount of profit, which is the credit we receive up front to assume the risk of the short contract. When selling a put option, we are betting against the movement of the stock price. This is a high probability trade because of one simple fact - instead of needing the stock to move down significantly, we can now be profitable at expiration if the stock stays the same, goes up, or even goes down a little bit, so long as the stock price stays above our short put strike.
Before we dig into long and short put contracts further, you need to have a basic understanding of how the options are priced to begin with. Option premium, or the actual value of an option itself, is made up of a blend of intrinsic (real) and extrinsic (time & implied volatility) value.
Intrinsic value for put options can be calculated at any time if the stock price is below the put strike. It is simply the distance between the strike price and stock price, multiplied by 100. This is real value, as it allows the long put owner to sell shares at a premium relative to the market price, and transfers perfectly from one expiration to the next.
Intrinsic value is static and easy to calculate. In the case of put options, intrinsic value is just the difference between where the stock price is and how far above the stock your strike price is.
This is because the long put contract allows you to sell 100 shares of stock at the strike price, so the contract has no real or intrinsic value if the strike price is below the stock price. Why would someone use their put contract to sell shares at $60 if they can just sell shares in the market at $75? It would not make sense to do so.
If you have a $60 strike put, and the stock is at $50 though, there would be $10.00 of intrinsic value in the contract. Since the contract represents the theoretical equivalent of 100 shares of stock, that is $1,000 of real value. It doesn’t matter what expiration you’re in, or how high or low implied volatility (the range of where the stock is implied to move in one years time) is. Intrinsic value is static, can always be calculated as long as it exists, and transfers perfectly from one expiration to the next, which is important to keep in mind moving forward.
Extrinsic value is all option value that is not intrinsic value. It is made up of time & implied volatility value, and will always decay to $0.00 by the option contract’s expiration. Further-dated options expirations will always have more extrinsic value than a near-term expiration on the same strike, and extrinsic value is always highest near the stock price.
Extrinsic value is simply all the leftover option premium or value that is not intrinsic value. You may be thinking…”does that mean that any put strike that is below the stock price is purely made up of extrinsic value?”. If this is what you’re thinking, you are correct! Extrinsic value can seem overwhelming, but there are a few simple ways to approach the concept, and it always comes back to the uncertainty of an option expiring with intrinsic value, or “in-the-money” (ITM). The more uncertainty there is, meaning the closer your strike is to the stock price, the more extrinsic value there will be:
Extrinsic value always decays to $0.00 in all options by expiration. At expiration, an option either has intrinsic value or it does not. Options that have intrinsic value will retain the intrinsic value that is easily calculated, and options that do not have intrinsic value, or options that are below the stock price in the case of put contracts, will be worthless.
Extrinsic value is always highest near the stock price, and decreases as you move away from the stock price to the downside (out-of-the-money or “OTM” for puts), and upside (in-the-money or “ITM” for puts). Options that are near the stock price have the highest uncertainty of being ITM/OTM at expiration, which is why they have the highest extrinsic value. Think of this concept as a bell curve of extrinsic value that peaks at the stock price, and follows the stock price wherever it goes. This bell curve collapses in on the stock price as expiration nears, and extrinsic value reaches $0.00.
Extrinsic value will always be higher in further-dated expirations if you are comparing the same strike price to a more near-term expiration. Just like a regular insurance contract, the more time associated with a contract, the more uncertainty there will be around where the stock price will be at expiration, and that increases extrinsic value.
Extrinsic value prevents an option from being assigned if it goes ITM. If an option slides ITM, but still has a lot of extrinsic value associated with it, assignment risk will be very low because the counterparty would be forfeiting that extrinsic value if they exercise the contract. Either way, risk does not change if a short option is assigned, since you assumed the risk of 100 long shares of stock at the strike price up front with the short put contract. It is similar to “fast forwarding” to expiration, where the option is converted to intrinsic value and extrinsic value is vaporized immediately.
Now that you have a basic understanding of intrinsic and extrinsic value, let’s dive into some examples to solidify the concepts, before diving into the short put contract and how to effectively defend it.
The further OTM you go, the less extrinsic value you will collect selling a put, but the lower your strike price and where you are potentially obligated to acquire 100 shares of stock at expiration will be.
The closer you are to the stock price, the more aggressive the trade will be, as you’ll collect more extrinsic value, which is your max profit on a short put trade.
Typically we aim to sell a put that is at-the-money (ATM, or near the stock price) or OTM. We want to give ourselves some wiggle room to the downside if we are wrong, and still profit if the stock doesn’t move. The further we move the strike below the stock price, the less extrinsic value we will collect. Remember, extrinsic value trails off as we move away from the stock price, both to the upside and downside. Lower extrinsic value means a lower max profit in the case of a short put, but also a lower cost basis if the stock ends up dropping and we acquire the shares below the current market price. In the example below, If I sold the $40 strike instead, it would certainly be worth less than $5.00. If I sold the $50 strike instead of the $45, it would be worth more than $5.00. This is just a simple tradeoff between risk and reward, and the question you should ask yourself is, where am I comfortable acquiring the stock, and how much am I looking to make on the trade if the stock hovers or rises in price?
Monthly expirations are typically the most liquid, and have the most fair markets from strike to strike
Longer-term expirations will have more extrinsic value than short-term expirations, because there is more uncertainty of where the stock will be at expiration, but extrinsic value will decay more slowly.
Remember, the further out in time you go, the more extrinsic value there will be. This also means that you may have to wait longer to achieve profit targets, even if the stock rallies, since there is so much time associated with longer-term contracts which will prevent them from reaching $0.00 extrinsic value. On the flip-side, shorter term contracts decay rapidly, but there isn’t much extrinsic value associated with them. We typically trade in the 30-60 DTE (days to expiration) range, with 45 DTE being the sweet spot. This gives us a healthy balance of time to be right, extrinsic value collected, and distance below the stock price we can go while still collecting a decent credit. The choice is yours, and it’s ultimately another tradeoff between risk & reward. Regular Monthly expiration cycles are typically the most liquid, meaning that is where the most activity takes place, which translates to more narrow bid-ask spreads (fair market price) when entering and exiting trades.
Here we have a short put option, trading for $5.00 or $500 real dollars, on the $45 strike. XYZ stock is currently trading at $50 per share.
Facts about this trade:
I am collecting $5.00 and assume the risk of 100 shares of long stock at $45. If a long put gives me the theoretical equivalent of 100 shares of short stock, a short put gives me the theoretical equivalent of 100 long shares of stock. My max loss is $4500 if the stock were to reach $0.00, less the extrinsic value of $500 I collect up front to assume the risk, leaving me with a max loss of $4000 at expiration if the stock were to go to $0.00, vs the $5000 max loss if I were to buy shares outright in the market right now.
This option is purely made up of extrinsic value right now, as it is a put contract I am selling below the stock price.
If the stock is anywhere above $45 at the expiration of my contract, I will make $5.00 or $500 real dollars.
My breakeven price on the trade is at $40. If the stock ends up at $40, my put will have $5.00 of intrinsic value, but I collected $5.00 of extrinsic value up front, so the trade would be a scratch.
If the stock is below my breakeven, I would see a net-loss on the trade. In this case, I would lose $5.00 or $500 real dollars, but I could decide to take the 100 shares of stock and hold them until they hopefully rise back up in price. In this case, my breakeven is still at $40 instead of $50 if I were to have purchased the shares outright instead of selling the put. The short put contract will always offer a lower cost basis than purchasing shares outright, which is why it is a high probability trade.
Short Put Recap:
Short puts offer us the ability to make money if the stock stays the same, goes up, or goes down a little bit, as long as the stock price stays above our short put strike price.
Short puts offer us the ability to acquire 100 shares of stock at a much lower cost basis than the market is currently offering, if we are comfortable with taking that risk.
So far, we’ve covered the short put basics, how long puts differ from short puts, what our intention is with short puts, and even how the put option price is calculated from an intrinsic & extrinsic value standpoint. Now it’s time to get our hands dirty with some more advanced concepts - how to roll positions defensively, reduce cost basis and improve probability of success, all while potentially increasing our max profit on the trade as well!
Rolling an option contract is defined as closing the current position and opening a new one, either in a different expiration, on a different strike, or a combination of both. In the case of a short put, this means buying back our current short put, and selling a new contract in a new expiration and/or a different strike price.
You may realize a loss when buying back your current put option, but if you are collecting a net credit on the roll, which is always possible when rolling the same strike out in time assuming the markets are liquid, that means you are selling a new option that is worth more than the loss you are realizing, and then some. If you sell a put for $1.00, and the stock price drops and the put is now trading for $2.00, you would see a loss of $1.00 overall. If you roll the put out in time, and collect another $1.00 credit for the roll, that means your new option’s value must be $3.00. You are buying back your $2.00 put for a debit, and selling a new put for a $3.00 credit, resulting in a net credit of $1.00. If the new put expires worthless, you wipe away the loss you realized, and actually increase your max profit by the extra $1.00 you collected for the roll. When you roll for a credit, you are adding to your credit received from the initial trade, reducing your breakeven and cost basis, adding more time to be right, and increasing your potential max profit as well. Let’s dig into a visual example below, to really solidify this important options trading concept.
There is a reason I went so in-depth in the beginning of this article - it is imperative to understand how your option is priced, period.
If you have a firm understanding of intrinsic and extrinsic value, it becomes much easier to manipulate and adjust short premium trades defensively, and learn new concepts and strategies altogether. Let’s take this example above, and blend it with the previous example, where we sold the $45 strike put, but let’s adjust our initial credit for selling the put to $1.00 with XYZ stock at $50. If we held all the way to expiration, and the stock is slightly below our put strike and trading for $2.00, we would have a net loss of $1.00. We would have collected $1.00 up front, and we would be buying back the MAR (March) cycle put for a $2.00 debit. But what if we want to extend the trade to give ourselves another shot at success? Take a look at the image above - notice the size of the blue dot under the put contract vs the yellow dot. The blue dot represents intrinsic value - as you can see, the dots are the same size when you compare MAR to APR (April). Again, it doesn’t matter what expiration you look at, how high or low IV is, intrinsic value transfers 1:1 from expiration to expiration.
So if the March $45 strike put is trading for $2.00, and the $APR $45 strike put is trading for $5.00, we know that the only possible difference in price MUST be extrinsic value! If I roll from MAR to APR, and I pay $2.00 to buy back the MAR $45 put, and collect $5.00 to sell the APR $45 put, I receive a net extrinsic value credit of $3.00.
What does this mean for my new trade?
This additional extrinsic value credit of $3.00 means that my initial credit of $1.00 is boosted to $4.00.
My new max profit is $4.00 if the $45 strike put expires worthless in APR
My new breakeven is down to $41, $3.00 lower than my previous breakeven of $44 if I sold the $45 strike put for a $1.00 credit initially.
As you can see, focusing on increasing extrinsic value with short put trades can significantly reduce cost basis, improve probability of success, and even increase max profit if the strike expires OTM eventually!
Instead of strictly sticking with the same strike, we have the ability to move our strike down as well if we choose to. In the first rolling example, we saw that we could buy back the MAR put for a $2.00 debit and collect a net credit of $3.00 by rolling the same strike out in time. But what if we want to reduce our cost basis aggressively, instead of increasing our max profit? How can we achieve this without adding risk to the trade?
We would need to sell an option in the new monthly cycle for the same amount, or slightly more than the debit we pay to close our current contract...
In this example, we are replacing our nice $3.00 net credit roll with a lower strike price - here, let’s assume we’re able to move our $45 strike down to $35 for a scratch. Focus on the colored dots again - in the MAR trade, we have a blend of intrinsic and extrinsic value, as the strike is slightly ITM. In this new APR cycle, we are actually moving the strike down below the stock price, and replacing that intrinsic value with extrinsic value in the APR cycle. If I buy back the $45 strike in MAR for a $2.00 debit, and sell a new APR 35 strike in APR for a $2.00 credit, I am effectively shifting my $2.00 MAR put value down 10 strikes to APR for the same value.
What does this mean for my new trade?
I am shifting my current position value of $2.00 that is ITM, to a new strike in APR that is 10 points lower than my old strike.
My max profit does not change, as I am not collecting any more extrinsic value premium. It remains at $1.00 if my NEW strike expires worthless, which now means the stock has to stay above $35 instead of $45.
My new breakeven is down to $34, which is significantly lower than the previous rolling example where we moved it from $44 to $41.
There are many ways to approach short put defense, but these are my favorite defensive strategies. Focusing on extrinsic value to increase max profit, reduce cost basis and breakeven price, improve probability of success, and even increase max profit if the new strike expires OTM are all achieved simply by collecting a credit when rolling out in time. Whether that means the same strike which means a more directional and aggressive trade, or moving the strike lower is up to you - at the end of the day, trading is all about risk:reward and being comfortable with both aspects of that tradeoff. If a short put moves ITM, it will have the same risk profile as a covered call on the same strike, so don’t panic if your short put strike goes ITM if you’re comfortable with that risk profile!
A short put is an effective options trading strategy to acquire 100 shares of stock at a lower cost basis than the market is offering right now.
Short puts are profitable if they are OTM at expiration, which means the stock can stay the same, go up, or even go down a little bit if we sold the put OTM initially.
Option Prices are made up of intrinsic value & extrinsic value, and intrinsic value can always be calculated with ITM options.
Short puts have intrinsic value if the strike is above the stock price.
Extrinsic value is any remaining value that is not intrinsic value, and will decay to $0.00 by expiration. If a put contract is below the stock price, the entire option premium is extrinsic value.
A short put breakeven is calculated by subtracting the credit received from the strike price. If this option is rolled for continuous credits, the breakeven moves lower and lower from the strike price.
All option extrinsic value is highest when the strike price is near the stock price, and trails off as you move away from the stock price.
Extrinsic value is always higher in further dated cycles than near-term cycles, so rolling the same strike out in time will always result in a net extrinsic value credit received, assuming the markets you’re trading are liquid.
Rolling a put out in time and down a few strikes for a scratch results in a lower cost basis through a lower strike price, not from an increase in extrinsic value.
Short puts that move ITM have the same risk profile as a covered call, so don’t panic if you are comfortable with that risk profile!
Hopefully this article has helped you expand your knowledge of options trading, whether it be intrinsic & extrinsic value, or short put strategy & defense. Be sure to re-watch the segment if you were fuzzy on concepts the first time around, as this article should be an in-depth resource for you to utilize in conjunction with my tradetalk!
Feel free to reach out to me with any questions on Twitter @tastytraderMike, or you can email me at firstname.lastname@example.org - if you’d like to learn more about these concepts and strategies, check out our free beginner options trading course here:
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