The Short Put Strategy - Selling Puts to Generate Income
Jim Graham

One way to generate income with puts is to simply sell them outright. While selling naked calls is a high risk strategy that is inappropriate for most investors, selling naked puts does not carry the same type of risk. With the short put strategy, at-the-money or just out-of-the-money puts are typically sold on stocks the investor wouldn’t mind owning. If the stock stays around the current price, or advances, the investor keeps the premium when the option expires worthless.
 
This strategy requires margin, so you have to put up enough cash in your brokerage account to “cover” the position in the event of exercise; thus, this strategy is also called the cash-secured put. What if the stock declines in price? In that case, the investor eventually gets assigned the shares, and the cost basis for his shares is the strike price of the put minus the premium received. That’s why naked put writers should be prepared to buy the stock (and make sure they have the funds available) before entering the position.
 
For example, consider a stock that is currently trading at $42.50. An out-of-the-money put with a strike price of 40 can be sold for $2.50, resulting in a credit to your account of $250. The $250 is yours to keep, no matter what. Worse case, you’ll end up paying $4,000 for 100 shares of stock. Subtract the $250, and your effective basis is $3,750, or $37.50 per share. Not a bad deal!
 
When you go naked with a put, you are hoping that the stock price will rise. It is a bullish position, and you have the same price expectations as you would when you buy calls. The difference, however, is that call buyers have to deal with time decay. They need the stock price to go up enough to cover the time value and produce a profit. Put sellers have time decay on their side, and are counting on time value to fall. A short put position can be profitable even if the stock does not move at all. So a key distinction between long calls and short puts is that it is more difficult to profit from buying calls; it is relatively easy to profit consistently from selling puts. The reason: time value. The decline in time value works against the buyer, but it is a valuable benefit to the seller.
 
Once you go naked on a put, you are exposed to the risk of having to buy 100 shares at the strike price. The owner of the put will only exercise the put if it is in-the-money, which means you would buy the stock at a price above the current market value. That might not be a terrible outcome, as long as you consider the strike price a fair price for the stock. The market is full of inaccuracies, and there are often companies whose stock is under-valued. In those cases, having 100 shares put to you could still be a bargain, as long as you are willing to wait out the market.
 
When you sell a put, you receive a premium which is credited to your account. That is income, but it also discounts the price of the stock in the event of exercise. So if the strike price is $40, and you get a premium of $2.50 when you sell the put, your cost basis would be $37.50 per share.   The range of outcomes is summarized in the figure below.
 

Short Put Analyzed

 
first thing you should notice is that the risk graph is exactly the same shape as the covered call strategy, but that the short put requires less capital. If the stock exceeds the breakeven point of $37.50 (the strike price of 40 less the 2.5 points of premium), the naked put is profitable. For each dollar the stock falls below that level, you lose another point. Even so, there are steps you can take to offset these losses. For example, you could immediately sell a call against the 100 shares to produce income. You can sell naked puts and wait for them to expire; or if they quickly lose their value because the stock price goes up, you can close out the position – and then repeat the process over and over, taking your profits without risking the capital needed to buy 100 shares of stock. Naturally your brokerage firm would require funds as collateral in the event of exercise.
 
Your opinion about a company’s true value might influence your decision to take on the risk of the naked put. When you go naked on a call, your risk is potentially unlimited, because a stock can go up without limits; but when you sell a put, your risk is limited to the difference between the striking price and zero. In theory, as long as the company has assets greater than its liabilities, your “real” risk could be considered limited to the difference between the strike price and the company’s tangible book value.