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Selling Out-of-the-Money Puts is a high probability, low gain option income strategy.

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Strategy: Short Put, OTM

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

Short Put Out of the Money Option Graph

The Outlook: Mildly bearish to bullish. The position will gain if the stock rises, stays put, or falls somewhat.

The Trade: Sell an OTM 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 beyond the breakeven price.

Maximum Loss : Unlimited.

Breakeven Calculation: Short Strike - option credit.

Advantages compared to stock: Credit entry, takes advantage of stock that does not move or moves within a range.

Disadvantages compared to stock: Limited potential gains, possible large percentage losses.

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 $4500.

Variations: Using an ATM strike will bring in a larger credit, but increase your chances of being put the stock.

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 there was no chance of a stock dropping below the sold strike, and you wanted to make some premium.
  • As a stock investor, this strategy might be used if you thought the current price of a stock was too high, but you wouldn't mind owning it if you could buy it at the strike price. If the stock falls to the strike price or below, you will be put the stock and you will pay the strike price x the number of shares represented by the puts you sold.
  • The idea of buying stock below the current market value sounds good at first. But there is no rule that says when a stock drops it is going to stop right at the strike price you sold. As a matter of fact, if the stock drops it could very well go much lower than the strike you sold. Then your bargain price will not look like a bargain anymore. You would be buying stock above the then-current market price instead of your original plan to buy below the current market price.
  • 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 by a good percentage amount to get you in trouble. The trouble is, you are actually making very small percentage gains on the amount of money tied up. And, you never know when a bull market is going to correct or end entirely. If you make $31 per trade as in the example, you can make $310 by doing the trade ten times. Then, maybe one time out of ten the stock drops $4 below the strike price you sold and you have to buy back the sold put for a $400 loss, nullifying the entire series of trades.
  • If you are tempted to use this strategy as a CSEP to buy stock below market value, remember that the only way to gain from owning a stock is if it goes up. Yet you are agreeing to buy the stock when it is going down, and you have no way of knowing how far down it will go.
  • 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 strategy can be used when the Implied Volatility is very high, but you do not expect a large drop in the stock price. This may be the case when a stock has had a sharp selloff that you do not expect to continue. With the IV so high, you can sell the puts for more than normal, which gives more downside protection and a larger gain if the stock does not drop too much. The graph below is the same as the example graph at the top of the page, but the IV has been raised to 70%.

Exits

  • Since this is a strategy with the potential for only small gains and possibly large losses, you must control the losses. If the example stock dropped to $45 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 as many 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!
  • Another way to try to salvage the trade is by shorting stock if the stock gets to the strike 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 meager credit you were trying to protect.

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