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The In-the-Money Short Put Option Strategy provides a way to participate in bullish price moves with no cash outlay.

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Strategy: Short Put, ITM

a.k.a. CSEP (Cash Secured Equity Put)

Short Put In the Money Option Graph

The Outlook: Mildly bullish. The position will gain if the stock rises, but the gains are limited relative to the risk.

The Trade: Sell an ITM put.

Gains when: Stock does not fall below the short strike - the credit received.

Maximum Gain: Limited to the initial credit.

Loses when: stock falls below the breakeven price.

Maximum Loss : Limited only by stock falling to zero.

Breakeven Calculation: Short Strike - option credit.

Advantages compared to stock: Initial credit, much greater leverage.

Disadvantages compared to stock: Limited potential gains, possible large percentage losses, no dividends.

Volatility: after entry, increasing implied volatility is negative.

Time: after entry, the passage of time is positive.

Margin 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, 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.

Variations: Using an ATM strike will bring in a smaller credit, but also lower the breakeven point.

Synthetic Equivalent: Covered Call using short calls at the same strike price.

Comments

  • As an options trader, this strategy might be used if you thought the stock was definitely going to rise. 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 concerned you might be missing a breakout. If in fact the stock does break out and rises to somewhere under $55, you will be put the stock at $55, but you took in over $5 in premium, so the net effect is that you paid less than $50 for the stock, and caught the breakout.
  • If the stock goes higher than $55, the put will expire worthless, and you can keep the entire premium. You don't own the stock, but you did catch at least $5 of the stock's rise.
  • During 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.

Exits

  • Since this is a strategy with the potential for limited gains and possibly large losses, you must control the losses. If the example stock dropped to $47.50 or so at any time, the trade should probably be exited for a relatively small loss. Trying to hang on could result in much larger losses.

Adjustments

  • 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 50 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!
  • Another 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.

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