How do traders combine a short put with other positions to hedge?

A trader can use short put options in a number different of ways, depending on the positions he is hedging and the options strategies he is using to hedge. A put option on equity stocks gives the holder the right, but not the obligation, to sell 100 shares of the underlying stock at the strike price up until the expiration of the put. A trader may sell a put to collect the premium by itself or as part of a larger options strategy.

There are many hedging strategies. For a long position in a stock or other asset, a trader may hedge with a vertical put spread. This strategy involves buying a put option with a higher strike price, then selling a put with a lower strike price. A put spread provides protection between the strike prices of the bought and sold puts. If the price goes below the strike price of sold puts, the spread does not provide any additional protection. This strategy provides a window of protection to the downside.

This strategy has advantages and disadvantages over just a bought put. The premium for the put spread is reduced by the amount of the sold put, minus commissions. While a put option owned outright generally loses value due to time decay, the vertical put spread suffers from less time decay due to the sold put.

For a short stock position, a trader could sell puts in a covered put strategy. He would sell puts in equal amounts to the short stock position. This is essentially the exact opposite of a covered call strategy, with the same risk of having the short stock position being called away if the sold put expires in the money.

(For related reading, see "Hedging With Puts and Calls.")