Derivatives

Mastering Derivatives: Shorting puts, a risky ride

Venkatesh Bangaruswamy | Updated on May 30, 2021

This strategy gives small profits frequently, but losses can be large infrequently

A reader of this column posed the following question: If several option strikes expire worthless, is it not profitable to short options? To address this question, this week, we look at the risk and returns associated with short put position.

Limited return, high risk

In options trading, the loss to a long position will equal the profit to a corresponding short position. Now, the maximum loss on a long put is the option premium. So, the maximum profit for a short put is the option premium. This maximum profit on the short put can be earned at expiry if the option expires out-of-the-money (OTM). For a put to expire OTM, the underlying price must be greater than the strike price.

These arguments lead to two observations: First, the profit from a short put, OTM and at-the-money (ATM) strikes, comes from time decay. This refers to loss in the option price due to two factors- passage of time and decline in implied volatility. This leads to the second observation- that a trader will prefer to short a put option if she/he is of an opinion that the underlying will move up marginally or remain sideways for a while. Note that if the trader expects the underlying to move up significantly, then buying a call could be more profitable.

Before discussing further, we wish to state an important point: Shorting options is risky because potential loss is greater than potential gain. True, shorting options is profitable most of the time. But loss can be substantial if there is an adverse movement in the underlying. For a short put, losses could be significant when the underlying declines during the life of the option and stays below the strike price at expiry. A short position can earn small profits frequently but can incur large losses infrequently, leading to a negatively-skewed returns distribution.

Your choice of a strike to short should be based on reverse implied volatility rule. That is, after selecting the ATM, the immediate OTM and the immediate in-the-money (ITM) strikes, you should choose the one with the highest implied volatility. This is because high implied volatility translates to high time value. And time decay (time value declining to zero) is the primary reason why short options are profitable.

The breakeven is equal to the strike price less the put premium. Suppose you short the 15200 put for 54 points when the underlying is at 15243 with three days to expiry. Your breakeven is 15146 (15200 less 54). If the underlying closes below this price at expiry, the short put position will generate losses. Note that time decay is faster when the option approaches expiry. That means it is optimal to short puts during the expiry week.

Optional reading

Suppose the underlying moves to 15300 with two days to expiry. The 15200 put would decline to 23 points. You can close your position for a 31-point profit (54 less 23). What if you expect the underlying to move up further or remain sideways through expiry? You could continue to hold the short position to improve your profits, as the put will expire worthless if the underlying stays above 15200 at expiry.

What if the underlying declines to 15200 a day before expiry? Your 15200 put could be worth 43 points; the 11-point profit can be attributed to a rapid time decay or theta despite the put becoming ATM. If the same decline in price happens two days before expiry, the put could be worth 60 points, which means the position would have gathered a six-point loss. This can be attributed to the increase in delta (accelerated by the gamma) working against the short position as the put moved from OTM to ATM. This factor dominated the loss in option price due to time decay, reiterating our argument- shorting options are risky.

The author offers training programmes for individuals to manage their personal investments

Published on May 30, 2021

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