An investor who has sold stock short can receive some protection and generate premium income by selling puts against their short stock position. Selling puts against a short stock position will only partially hedge the unlimited upside risk associated with any short sale of stock. Additionally, the investor, in exchange for the premium received for the sale of the put, has further limited their maximum gain. Before entering a short stock short put position, an investor must determine:

  • Their Breakeven
  • Their Maximum Gain
  • Their Maximum Loss

Breakeven Short Stock Short Puts

An investor who has sold stock short and sold puts against their position is subject to a loss if the stock price begins to rise. To determine how high a stock price could rise after establishing a short stock short put position and still allow the investor to breakeven, use the following formula:

Breakeven = Stock Price + Premium

Example:

An investor establishes the following position:

Short 100 ABC at 55

Short 1 ABC November 55 put at 4

Using the above formula, we get:

55 + 4 = 59

In this case, the stock could rise to $59 by expiration and still allow the investor to breakeven excluding transaction costs.

Maximum Gain Short Stock Short Puts

An investor who has established a short stock short put position has limited the amount of their gain even further by selling puts, because the investor will be required to purchase the shares at the put’s strike price if the stock declines.

To determine the investor’s maximum gain use the following formula:

Maximum Gain = Breakeven – Strike Price

Example:

An investor establishes the following position:

Short 100 ABC at 55

Short 1 ABC November 55 put at 4

The investor will breakeven at 59 found by adding the stock price of 55 and the option premium of 4 together.

Using the above formula, we get:

59 - 55 = 4

The investor’s maximum gain in this case is $4 per share or $400 for the entire position. The investor received a total of $59 per share by establishing the position. If the stock fell to zero they would still be required to repurchase the shares at 55 under the terms of the put contract. Notice that the sales price and the put’s exercise price are the same and the amount of the investor’s maximum gain is equal to the amount of the premium received.

Let’s look at a position where the sale price of the stock and the strike price of the put are different.

Example:

An investor establishes the following position:

Short 100 XYZ at 60

Short 1 XYZ November 55 put at 4

The investor will breakeven at 64. $64 dollars per share were the total proceeds received by the investor for establishing the position.

To determine their maximum gain using the formula above, we get:

64 – 55 = 9

The investor’s maximum gain is $9 per share or $900 for the total position.

Maximum Loss Short Stock Short Puts

An investor who has sold puts against their short stock position has only limited their loss by the amount of the premium received from the sale of the put. As a result, the investor’s loss in a short stock short put position is still unlimited.

Underlying Position Most Protection Some Protection & Income

Long Stock

Long Puts

Short Calls

Short Stock

Long Calls

Short Puts

FOCUS POINT!

It’s important to note that any time an investor wants the most protection, they are going to buy the hedge. If the investor wants some protection and income, they will sell the hedge.

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