Short put strategy I: How to buy stock at a lower price? A thorough explanation with AAPL's example

Among various options strategies, the short put is one of the commonly used strategies. It may allow investors to either generate additional income through premiums or potentially acquire shares at a lower effective price.

This article will illustrate how to use short put strategy to buy stock at a lower target price, or a "sell-to-buy-stock put", and the relevant risk, with a real stock world's example of $Apple (AAPL.US)$. After reading this article, you will have a comprehensive understanding of this strategy. The next article will detail how to use the short put to enhance returns. So, stay tuned!

Basics of Short Put

What is Short Put:

A short put is to sell a put option contract. Investors will receive a premium income while simultaneously undertake the obligation to buy the underlying asset at the strike price at or in advance of the expiry. Since this involves a potential future obligation, securities brokers will usually require a margin, typically 5 to 10 times the premium received.

Pay-off:

Upon the expiry of the contract, if the stock price is above the strike price, the option would not be exercised, meaning the investor effectively receives the premium "as profit." If the stock price falls below the strike price at expiration, the contract would likely be exercised, resulting in the investor being assigned at the strike price.

Core Idea:

The short put strategy is generally used when an investor is moderately bullish on the long-term outlook of a company and is willing to acquire its shares if prices fall to a certain level. The strike price represents the maximum price the investor is prepared to pay for the stock.

Common Mistake:

Investors should avoid using a short put strategy on companies they are NOT confident about. Even if the strike price is below the current market price, weak fundamentals or negative outlook could result in the stock continuing to decline after assignment. This is a common mistake made by beginners, as they focus only on the “discounted entry price” without considering the underlying company’s quality.

Recently, $Apple (AAPL.US)$ has several positive catalysts, and its share price has rebounded significantly. We will use Apple as an example to illustrate the specific application of how the short-put strategy works.

Strike Price and Expiration for Sell-to-Buy-Stock Put

(1) Strike Price:

For investors who use short put to buy stock, the strike price should not be set too far from the spot price. Let's use Apple's example.

Assuming Apple's current stock price is $225, and the investor believes in Apple's long-term value but is unwilling to buy its shares at the current price, they may set the strike price at $205 (approximately 10% below the current price).

Generally, a strike price 10% to 15% below the current price is feasible. A lower strike price would significantly reduce the probability of assignment.

(2) Term:

The term should not be too long, generally not exceeding three months, to avoid the risk of missing out on potential gains due to a rapid rise in the stock's price. If the short put prevents the investor from buying the underlying stock and the stock price continues to rise sharply, then the profit missed out could be gigantic, as the maximum profit from the short put is capped.

Scenario Analysis

Assume $Apple (AAPL.US)$ Apple's current stock price is $227. An investor enters into a short put position with a strike price of $205 and a three-month expiration, receiving a premium of $3.55 per share.

At the time of entering the position, the investor receives a premium of $3.55 per share. Scenarios thereafter can be divided into four categories:

(1) stock price: 210

At expiration, if Apple's stock price is $210 (still above $205), the investor earns a net income of $3.55 per share. Compared to the strike price of $205, the $3.55 premium represents a rate of return of approximately 1.73%, annualized 6.9%.

At this point, the investor can continue the short put strategy, for example, by entering into another position with a strike price of $190 and a three-month expiration. By rolling the position over throughout the year, the investor can achieve an actual annual rate return of 6.9%.

(2) stock price: 200

If Apple's stock price is $200 (below $205) at the option's expiry, the option is exercised, and the investor buys Apple stock at $205. Due to the $3.55 per share premium, the actual cost basis is $201.45 per share. Note that since most options are American-style, meaning they can be exercised at any time, investors do not have to wait until expiration. They can choose to exercise as soon as the stock price falls below $205, which has the same effect as holding until expiration but with time efficiency.

(3) stock price: 235

At expiration, if Apple's stock price is $235, the investor still retains the full premium of $3.55 per share. However, the underlying stock's gain is $235 - $225 = $10 per share, which exceeds the return from the option. In this case, the short put strategy underperforms compared to directly buying the underlying stock.

This is one of the long-tail risks of the short put strategy: if the underlying stock rises rapidly, the limited profit potential might constrain the investor's potential gains.

In other words, if the investor opens a short put position and the stock price rises rapidly, he should set a profit-taking level. Once the stock price breaches this level, the option position should be closed promptly and the investor should assess whether the underlying stock has the potential for continued rapid appreciation. If the outlook is strong, it may be more suitable to buy the underlying. If not, the investor could consider continuing with the short put strategy directly or after stock price's pullback.

(4) stock price: 190

Finally, if the stock price falls to $190 at expiration, the investor, having bought at $205, would incur a loss of $15 per share. Although the $3.55 premium partially offsets this, the net loss is still $11.45 per share (5.6%). If the stock price continues to fall, the investor would be trapped.

This is another source of risk of the short put strategy: a rapid decline in the stock price could leave the investor's profit eroded, contrary to the original goal of accumulating shares at a lower price. This also proves the axios that if the investor is not solid on the stock's long-term potential, they should not engage in the short put strategy even if it allows them to accumulate shares at a lower price.

Summary

The sell-to-buy-stock put strategy is generally suitable for stocks with solid fundamentals and high long-term investment value. Yet, investors should also consider the implied volatility (IV) of the stock. In our earlier example, Apple's IV is typically around 28, which is relatively low but still allows for a reasonable premium. If a stock's IV is below 22, the premium received would be too low, as seen with stocks like $McDonald's (MCD.US)$ McDonald's, $NASDAQ (NASDAQ.US)$ Nasdaq, or $Walmart (WMT.US)$ Walmart. In such cases, any short side option strategy is generally no longer applicable.

In the next article, we will use $Palantir (PLTR.US)$ as an example of relatively high implied volatility stock to explain how to use short put for premium-collection and return enhancement. So, stay tuned!

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