What is a 'Short Put'
A short put is a type of strategy regarding the selling of a put option. The option itself is a security in its own right, as it can be purchased and sold. Should the holder of the option believe that the price of the underlying security will increase before the contract’s expiration date, the option holder may buy the underlying stock, or may sell the put option (hence “short put”), which requires him to buy the stock, should the put buyer demand he do so.
BREAKING DOWN 'Short Put'A short put is also known as an uncovered put or a naked put. If an investor writes a put option, the investor is obligated to purchase shares of the underlying stock if the put option holder exercises the option, or if the option expires in the money.
Short Put Mechanics
A short put position is effectively a form of insurance, guarding the investor against losses beyond a certain point. When the investor enters a short put position, the security’s price must rise in order for the strategy to turn a profit. Furthermore, the price must rise by at least the price of the put option, or the “premium”. The higher the price rises, the more money the investor makes. Conversely, should the investor have initially erred and the security’s price then falls, the strategy would lose money. The upper bound on the losses is the value of the stock.
When an investor enters into a short put strategy, he is locking the price of an underlying security at the strike price and keeping the premium for writing the put option. Entering into a short put position is considered a risky strategy because an investor is bound by a profit limited to the premium received for selling the put option. However, he is exposed to a higher potential loss only bounded by the strike price of the naked put option minus the premium received, because the underlying stock price can only go to zero.
Short Put Example
Assume an investor is slightly bullish on hypothetical stock ECC Corporation, which is currently trading at $30 per share. The investor believes the stock will steadily rise to $40 over the next month. However, the investor does not have enough cash to purchase the underlying stock. Consequently, the investor writes one put option with a strike price of $32.50 expiring in one month, for $5.50. Therefore, the maximum gain is limited to $550, or $5.50 * 100, since equity options have a multiplier of $100. Conversely, the maximum loss is $2,700, or ($32.50 - $5.50) * 100.
To understand the basics of selling put options, see "Introduction to Put Writing."