As we have learned a ‘Short Call’ earlier; now, we will discuss a ‘Short Put.’
A short put involves the selling of a put option. It is a slightly bullish and neutral strategy. A short put has limited profit potential, which is the premium received and unlimited risk. A short put strategy has a positive pay-out when there is an increase in the underlying stock or volatility contraction. It declines in value from a decline in the underlying stock or volatility expansion.
Below is the illustration of the payoff diagram of a Short Put Option:
The key incentive of selling a put is that you can profit under three scenarios:
- when the underlying stock rise,
- move sideways,
- or fall slightly
The probability of success in the trade is 2/3rd. An advantage of selling a naked put is that it can be structured to have a higher probability of success than trading the underlying stock or buying a put. A disadvantage to selling any option is that you have unlimited risk if the asset price falls and goes below the strike price.
A Put option seller has time on his side and with each passing day, premiums fall considering other factors don’t move much.