Is Selling Put Options Safe Or Risky?

One of the most popular Options strategy is the Short Put.

Sell a Put Option, collect premium, and rinse and repeat.

But is it a safe strategy?

Or is it inherently a risky and dangerous strategy?

On one end, there are people who say that they’ve made lots of money selling Put Options.

But on the other end, there are people who say that they’ve lost all their money because of selling Puts.

So who is telling the truth?

And should you be selling Put Options?

Or should you be avoiding it like the plague?

Let’s dig deeper into this to find out the truth.

Buying Shares VS. Selling Puts

To determine whether selling Puts is safe or risky, we want to compare it to the alternative.

And that is to buy shares.

So for this example, we will be buying 100 shares at $100 and compare it to selling a Put Option with the strike price of 100.

Now, if the stock drops to $80, what would be the loss for both of these positions?

The image above shows the risk profile of the stock position versus the Short Put.

As you can see, if the stock drops to $80, the stock would lose $2,000 but the Short Put would lose less than that.

And that’s because the stock position is always 100 deltas.

That means it loses $1 for every dollar move in the stock.

However, that’s different for the Short Put.

An At-The-Money (ATM) Short Put is around 50 deltas.

Only when the Short Put gets deeper In-The-Money (ITM) that the delta will increase.

That means that the Short Put will lose lesser at the start, and will only gradually has its losses increase as the delta grow bigger.

But it will never exceed the loss of the 100 shares position.

Hence, the Short Put is actually less risky than a Long stock position.

Why People Lose Lots of Money With The Short Put

So if selling Puts is actually less risky than buying stocks, why is it that many people lose lots of money with Short Puts?

And that’s because of the BPR (buying power reduction/buying power effect).

The BPR is basically the capital you need to put up for initiating the Option position.

So in the image above, the BPR for initiating the Short Put position is -$1,000 (rounded down).

That means you need that available capital in your account to be able to open this position.

And this is where many new traders get into trouble.

If they have a $5,000 account, they think they can sell 5 Short Puts.

And for the 5 Short Puts, they are able to receive a total premium of $250 x 5 = $1,250.

However, what they don’t realize is the risk involved in the position.

If you were to look at the “Max Loss” row in the image above, it shows $9,750.

That means the potential loss for each Short Put is $9,750.

And 5 Short Puts would mean a total potential loss of $9,750 x 5 = $48,750.

That means if there’s a big enough move to the downside, the trader can easily have his account wiped out.

So exactly how far does the stock need to move to wipe out the account?

For this, we have to refer to the risk profile.

You can see that if the market goes down to around $90.84, it would be at a loss of -$5,003.87.

So all it takes is for the stock to move down roughly 9% – 10% for the trader to wipe out his account.

How To Make Selling Puts “Safer”

So how do you make the Short Put strategy safer?

Here are a few ways.

1) Ensure you know what’s the maximum risk in the worst-case scenario.

Most traders only focus on how much they can make on a trade.

But they ignore the fact that you can lose money on the trade, no matter how high the probability of the trade is.

So it’s important to plan out all the scenarios that can happen after placing the trade, and identify what the worst-case scenario is.

Once you know what the worst-case scenario is, you will be able to know what your max loss can potentially be.

2) Risk on 5% – 7% of your capital on any trade.

When you only risk a small percentage of your capital for each trade, even if you hit the max loss, it would be a small percentage of your account.

You would still have more than sufficient capital to fight back and be in the game long enough to be profitable.

So for example, if your account size is $10,000, then you can only risk $500 – $700 per trade.

And this $500 – $700 is based on the Short Put’s BPR.

So if the BPR shows $1,000, it means it’s too big for your account size.

You would need to find a smaller product to trade.

3) Manage your Short Put at 21 DTE

There have been numerous studies done by the folks at TastyTrade that show your risk is significantly reduced when you manage your trades at 21 DTE.

In the chart above, it shows that if you manage your trades at 21 DTE, the chances of you having a loss that exceeds the BPR are very low.

In fact, if you trade the Index ETFs (GLD, SPY, XLE), you have no losses that exceed the BPR.

That means that your max potential loss will always be contained by the trade’s BPR.

This way we’re able to more effectively position size our trades without worrying that a trade can exceed the capital we allocated to it.

4) Only sell Puts on fundamentally good stocks

Many people tend to sell Puts on stocks that just have high volatility.

And that’s because high volatility increases the premium received.

However, not many people realize that high volatility also comes with added risks.

The volatility on these stocks is high because they can make huge moves.

And such stocks tend to be non-fundamentally good stocks.

That means in the long run, the stock could go to zero.

And since the Short Put is a bullish strategy, it’s better to use the strategy on fundamentally good stocks.

This way it has a higher probability of it going up than down.

So how do you know what is considered a “fundamentally good” stock?

Here are a few criteria:

• Companies that are steadily increasing their revenue over time.
• Companies that are steadily increasing profits over time.
• Have relatively low debt.

For example, if you compared Google with Gamestop, you can see that Google has all the criteria of a fundamentally good stock.

Whereas Gamestop has very erratic revenue and profit.

And if you compare both the stock price movement, Google has kept going up over the years.

Whereas Gamestop has very erratic price swings.

So are Short Puts safe or risky?

At the end of the day, all Options have risks.

That means there’s always the possibility that you can lose money on any single trade.

However, it is not as risky compared to buying stocks.

That’s the misconception that many people have.

They think that buying stock is safer than selling Put Options when the opposite is true.

So while there’s risk in selling Puts (and also in buying stocks), there are ways to reduce the risk.

And if you’re able to manage your risk well, then you can be profitable over the long run.