An ATM short
put option strategy has the same profit and loss graph as a covered call
using the same strike price, but the trade is entered for a credit instead
of a debit.
option-info and options-graphs sites:
(Cash Secured Equity Put)
Outlook: Neutral to bullish. The position will gain if the stock
falls slightly, stays put, or rises, but the gains are limited relative
to the risk.
Sell an ATM put.
when: Stock does not fall below the short strike - the credit received.
Gain: Limited to the initial credit.
when: stock falls below the breakeven price.
Loss : Limited only by stock falling to zero.
Calculation: Short Strike - option credit.
compared to stock: Initial credit, much greater leverage.
compared to stock: Limited potential gains, possible large percentage
losses, no dividends.
after entry, increasing implied volatility is negative.
after entry, the passage of time is positive.
Requirement : If you have permission from your broker to trade naked
options, the minimum margin is normally 10% of the put strike price +
the put premium, but it can be higher. If the trade is done as a CSEP
(cash secured equity put), your broker will require you to maintain cash
in the full amount necessary to buy the stock at the strike price. In
the example that would be $5500.
Using an ITM strike will bring in a larger credit, but also raise
the breakeven point.
Equivalent: Covered Call using short calls at the same strike price.
- As an
options trader, this strategy might be used if you thought the stock
had a good chance of rising. Being short a put allows you to participate
in the rise with no cash outlay.
- As a stock
investor, this strategy might be used if you were comfortable and successful
using the Covered Call strategy, and wanted to have the same types of
dollar returns without actually buying stock.
bull markets, this strategy almost seems too good to be true. You can
make premium with no actual investment, and the stock would have to
fall to get you in trouble. The trouble is, you never know when a bull
market is going to correct or end entirely. You must always exit the
trade with a limited loss if it starts to go against you, in order to
protect against unlimited losses.
- One of
the biggest problems with this strategy is the potential for large drops
in the stock price, from analyst downgrades or unexpected bad earnings
announcements or any other unforeseen event. Even if you set very reasonable
stop-loss points, there is no guarantee the stock won't gap much lower.
- The graph
of this strategy is the same as the graph of a Covered Call using the
same strike price. You might want to read the Covered
Call strategy page and the Covered
Call Strategies Disadvantages page if you are considering this strategy.
this is a strategy with the potential for limited gains and possibly
large losses, you must control the losses. If the example stock dropped
below the breakeven price at any time, the trade should probably be
exited for a relatively small loss. Trying to hang on could result in
much larger losses.
- A trader
can possibly attempt to adjust his way out of a losing short put by
putting the day of reckoning farther out into the future, on more puts.
For instance, if the stock in the example fell to $45, you would have
a loss, but you might be able to roll to twice the number of 45 strike
short puts with a month more time left, for about even money.
If the stock recovers you may be able to get out with a small gain,
but if the stock does not recover the adjustments become unsustainable
after a while. You might need to sell 4, then 8, then 16, and so on,
just to avoid taking the original loss. Ask yourself if you want to
be holding 16 short puts during a bear market!
way to try to salvage the trade is by shorting stock if the stock falls
to the breakeven price. Then if the stock continues lower, the losses
on the short put are matched by gains in the short stock. However, if
the stock reverses you will now have losses on short stock which could
easily wipe out the credit from the put you were trying to protect.