Short Put Ladder Explained

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Short Put Ladder

Definition:
A put option is an option contract in which the holder (buyer) has the right (but not the obligation) to sell a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).

For the writer (seller) of a put option, it represents an obligation to buy the underlying security at the strike price if the option is exercised. The put option writer is paid a premium for taking on the risk associated with the obligation.

For stock options, each contract covers 100 shares.

Buying Put Options

Put buying is the simplest way to trade put options. When the options trader is bearish on particular security, he can purchase put options to profit from a slide in asset price. The price of the asset must move significantly below the strike price of the put options before the option expiration date for this strategy to be profitable.

A Simplified Example

Suppose the stock of XYZ company is trading at $40. A put option contract with a strike price of $40 expiring in a month’s time is being priced at $2. You strongly believe that XYZ stock will drop sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 XYZ put option covering 100 shares.

Say you were spot on and the price of XYZ stock plunges to $30 after the company reported weak earnings and lowered its earnings guidance for the next quarter. With this crash in the underlying stock price, your put buying strategy will result in a profit of $800.

Let’s take a look at how we obtain this figure.

If you were to exercise your put option after earnings, you invoke your right to sell 100 shares of XYZ stock at $40 each. Although you don’t own any share of XYZ company at this time, you can easily go to the open market to buy 100 shares at only $30 a share and sell them immediately for $40 per share. This gives you a profit of $10 per share. Since each put option contract covers 100 shares, the total amount you will receive from the exercise is $1000. As you had paid $200 to purchase this put option, your net profit for the entire trade is $800.

This strategy of trading put option is known as the long put strategy. See our long put strategy article for a more detailed explanation as well as formulae for calculating maximum profit, maximum loss and breakeven points.

Protective Puts

Investors also buy put options when they wish to protect an existing long stock position. Put options employed in this manner are also known as protective puts. Entire portfolio of stocks can also be protected using index puts.

Selling Put Options

Instead of purchasing put options, one can also sell (write) them for a profit. Put option writers, also known as sellers, sell put options with the hope that they expire worthless so that they can pocket the premiums. Selling puts, or put writing, involves more risk but can be profitable if done properly.

Covered Puts

The written put option is covered if the put option writer is also short the obligated quantity of the underlying security. The covered put writing strategy is employed when the investor is bearish on the underlying.

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Naked Puts

The short put is naked if the put option writer did not short the obligated quantity of the underlying security when the put option is sold. The naked put writing strategy is used when the investor is bullish on the underlying.

For the patient investor who is bullish on a particular company for the long haul, writing naked puts can also be a great strategy to acquire stocks at a discount.

Put Spreads

A put spread is an options strategy in which equal number of put option contracts are bought and sold simultaneously on the same underlying security but with different strike prices and/or expiration dates. Put spreads limit the option trader’s maximum loss at the expense of capping his potential profit at the same time.

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Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Short Put

What is a Short Put

A short put refers to when a trader opens an options trade by selling or writing a put option. The trader who buys the put option is long that option, and the trader who wrote that option is short. The writer (short) of the put option receives the premium (option cost), and the profit on the trade is limited to that premium.

Basics of the Short Put

A short put is also known as an uncovered put or a naked put. If an investor writes a put option, that investor is obligated to purchase shares of the underlying stock if the put option buyer exercises the option. The short put holder could also face a substantial loss prior to the buyer exercising, or the option expiring, if the price of the underlying falls below the strike price of the short put option.

Short Put Mechanics

A short put occurs if a trade is opened by selling a put. For this action, the writer (seller) receives a premium for writing an option. The writer’s profit on the option is limited to that premium received.

Initiating an option trade to open a position by selling a put is different than buying an option and then selling it. In the latter, the sell order is used to close a position and lock in a profit or loss. In the former, the sell (writing) is opening the put position.

If a trader initiates a short put, they likely believe the price of the underlying will stay above the strike price of the written put. If the price of the underlying stays above the strike price of the put option, the option will expire worthless and the writer gets to keep the premium. If the price of the underlying falls below the strike price, the writer faces potential losses.

Some traders use a short put to buy the underlying security. For example, assume you want to buy a stock at $25, but it currently trades at $27. Selling a put option with a strike of $25 means if the price falls below $25 you will be required to buy that stock at $25, which you wanted to do anyway. The benefit is that you received a premium for writing the option. If you received a $1 premium for writing the option, then you have effectively reduced your purchase price to $24. If the price of the underlying doesn’t drop below $25, you still keep the $1 premium.

The profit on a short put is limited to the premium received, but the risk can be significant. When writing a put, the writer is required to buy the underlying at the strike price. If the price of the underlying falls below the strike price, the put writer could face a significant loss. For example, if the put strike price is $25, and price of the underlying falls to $20, the put writer is facing a loss of $5 per share (less the premium received). They can close out the option trade (buy an option to offset the short) to realize the loss, or let the option expire which will cause the option to be exercised and the put writer will own the underlying at $25.

If the option is exercised and the writer needs to buy the shares, this will require an additional cash outlay. In this case, for every short put contract the trader will need to buy $2,500 worth of stock ($25 x 100 shares).

Key Takeaways

  • A short put is when a trader sells or writes a put option on a security.
  • The idea behind the short put is to profit from an increase in the stock’s price by collecting the premium associated with a sale in a short put. Consequently a decline in price will incur losses for the option writer.

Short Put Example

Assume an investor is bullish on hypothetical stock XYZ Corporation, which is currently trading at $30 per share. The investor believes the stock will steadily rise to $40 over the next several months. The trader could simply buy shares, but this requires $3,000 in capital to buy 100 shares. Writing a put option generates income immediately, but could create a loss later on (as could buying shares).

The investor writes one put option with a strike price of $32.50, expiring in three months, for $5.50. Therefore, the maximum gain is limited to $550 ($5.50 x 100 shares). The maximum loss is $2,700, or ($32.50 – $5.50) x 100 shares. The maximum loss occurs if the underlying falls to zero and the put writer needs to still buy the shares at $32.50. The loss is partially offset by the premium received.

Short Put Ladder

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. Support for this pricing relationship is based upon the argument that arbitrage opportunities would materialize if there is a divergence between the value of calls and puts. Arbitrageurs would come in to make profitable, riskless trades until the put-call parity is restored.

To begin understanding how the put-call parity is established, let’s first take a look at two portfolios, A and B. Portfolio A consists of a european call option and cash equal to the number of shares covered by the call option multiplied by the call’s striking price. Portfolio B consist of a european put option and the underlying asset. Note that equity options are used in this example.

Portfolio A = Call + Cash, where Cash = Call Strike Price

Portfolio B = Put + Underlying Asset

It can be observed from the diagrams above that the expiration values of the two portfolios are the same.

Call + Cash = Put + Underlying Asset

Eg. JUL 25 Call + $2500 = JUL 25 Put + 100 XYZ Stock

If the two portfolios have the same expiration value, then they must have the same present value. Otherwise, an arbitrage trader can go long on the undervalued portfolio and short the overvalued portfolio to make a riskfree profit on expiration day. Hence, taking into account the need to calculate the present value of the cash component using a suitable risk-free interest rate, we have the following price equality:

Put-Call Parity and American Options

Since American style options allow early exercise, put-call parity will not hold for American options unless they are held to expiration. Early exercise will result in a departure in the present values of the two portfolios.

Validating Option Pricing Models

The put-call parity provides a simple test of option pricing models. Any pricing model that produces option prices which violate the put-call parity is considered flawed.

You May Also Like

Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    The Best Binary Options Broker 2020!
    Perfect For Beginners!
    Free Trading Education, Free Demo Account!
    Get Your Sing-Up Bonus Now!

  • Binomo
    Binomo

    Good Broker. Only For Experienced Traders!

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