Short Put Option: Maximum Profit & Loss Calculations on Short Put Option: Options, Futures, Derivatives & Commodity Trading

Short Put Option: Maximum Profit & Loss Calculations on Short Put Option

Short Put Option: Maximum Profit & Loss Calculations on Short Put Option
Continuing further from the previous article Short Put Option Trading Strategy, we cover an example for calculating profit and loss from short put option trading.
How to calculate the Short Put Option Profit and Loss?
Maximum profit from Short Put Option Position
Your profit will be to the maximum value of the money you received from the sale of put option i.e. the option premium.
In the example taken above, your maximum profit will be $5. Short Put Option

Maximum Loss from Short Put Option Position
Your maximum loss will be when the option is exercised by the buyer with the maximum difference between strike price and the underlying.
And the maximum difference will be achieved only when the underlying price goes to ZERO i.e. company goes bankrupt.
So your maximum loss in a short put position will be equal to strike price i.e. $30 ($30 - $0 = $30).
However, you earlier received $5 from the sale of put option, hence taking that into consideration, your maximum loss is at $25.
Maximum Loss from Short Put Option Position: Strike Price - Unerlying Price on Expiry/Exercise Date - Option Premium Received

What are the benefits of Short Put Option Trading?
A short put option is limited loss limited profit position.
When you short an option, you implicitly benefit from Options Time Decay that works in your favour (see Options Time Decay: Time Decay in Options Explained with Example).
You get the option premium upfront and hence you can earn interest on that money. However, interest payment on trading money differs from one broker to another.

What are the risks of Short Put Option Trading?
Although short put position is said to be limited profit limited loss position, the fact is that the limited profit potential you have is very small compared to the limited loss potential which can go very large.
Imagine what will be the result if you short a $100 strike put for $5 option premium and the stock price goes down to $50.
You will suffer a $50 loss, i.e. 10 times more loss than the $5 profit.

Another thing is that short positions require a lot of margin money to be kept with the futures and options brokers. Since it is a big loss making position, the brokers need to ensure that they have sufficient coverage for margin calls. This might hit your trading strategy.
Hence an option trader must consider all these risks before diving into a short option position.

What is the best way to benefit from Short Put Option Trading Strategy?
If you are buying the simple naked short put position - i.e. not clubbing it with anything, then the trading strategy for Short Put Option will be to have a clear target level and stop loss level.
You get into a Short Put Option Trading Position when you have a BULLISH view. However, if your view does not come true, then you might suffer big losses (much larger compared to the profit potential you have
So the risk is always there. Hence while trading on a single Short Put Option Position, it's always better to have a target and stop loss in mind and get out of that position when that target is achieved or stop loss is hit.
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