/stock-exchange-911608_1920-10d732f18b394e489f017932acd95d10.jpg)
Selling (also called writing) a put option allows an investor to potentially own the underlying security at a future date and at a more favorable price. In other words, the sale of put options allows market players to gain bullish exposure, with the added benefit of potentially owning the underlying security at a future date and at a price below the current market price.
Key Takeaways
- Selling (also called writing) a put option allows an investor to potentially own the underlying security at a future date and at a more favorable price.
- Selling puts generates immediate portfolio income to the seller, who keeps the premium if the sold put is not exercised by the counterparty and it expires out-of-the-money.
- An investor who sells put options in securities that they want to own anyway will increase their chances of being profitable.
- Note that the writer of a put option will lose money on the trade if the price of the underlying drops prior to expiration and if the option finished in-the-money.
Call Options vs. Put Options
A quick primer on options may be helpful in understanding how writing (selling) puts can benefit your investment strategy, so let’s examine a typical trading scenario, as well as some potential risks and rewards.
An equity option is a derivative instrument that acquires its value from the underlying security. Buying a call option gives the holder the right to own the security at a predetermined price, known as the option exercise price.
Conversely, buying a put option gives the owner the right to sell the underlying security at the option exercise price. Thus, buying a call option is a bullish bet–the owner makes money when the security goes up. On the other hand, a put option is a bearish bet–the owner makes money when the security goes down.
Selling a call or put option flips over this directional logic. More importantly, the writer takes on an obligation to the counterparty when selling an option; the sale carries a commitment to honor the position if the buyer of the option decides to exercise their right to own the security outright.
Here’s a summary breakdown of buying vs. selling options:
- Buying a call: You have the right to buy a security at a predetermined price.
- Selling a call: You have an obligation to deliver the security at a predetermined price to the option buyer if they exercise the option.
- Buying a put: You have the right to sell a security at a predetermined price.
- Selling a put: You have an obligation to buy the security at a predetermined price from the option buyer if they exercise the option.
How To Sell Put Options To Benefit In Any Market
Best Practices for Selling Put Options
Investors should only sell put options if they’re comfortable owning the underlying security at the predetermined price because you’re assuming an obligation to buy if the counterparty chooses to exercise the option.
In addition, you should only enter trades where the net price paid for the underlying security is attractive. This is the most important consideration in selling puts options profitably in any market environment.
Other benefits of put selling can be exploited once this important pricing rule is satisfied. The ability to generate portfolio income sits at the top of this list because the seller keeps the entire premium if the sold put expires without exercise by the counterparty. Another key benefit is the opportunity to own the underlying security at a price below the current market price.
Put Selling in Practice
Let’s look at an example of prudent put selling. Suppose that Company A is dazzling investors with increasing profits as a result of a new, revolutionary product. Company A’s stock is currently trading at $270 and the price-to-earnings ratio is at an extremely reasonable valuation for this company’s fast growth track. If you’re bullish about their prospects, you can buy 100 shares for $27,000, plus commissions and fees.
As an alternative, you could sell one January $250 put option expiring two years from now for just $30. That means the option will expire on the third Friday of January two years from now, and it has an exercise price of $250. One option contract covers 100 shares, allowing you to collect $3,000 in options premium up front (less commission).
By selling this option, you’re agreeing to buy 100 shares of Company A for $250, no later than January, two years from now. Clearly, since Company A shares are trading for $270 today, the put buyer isn’t going to sell you the shares for $250, as that is $20 below the current market price. So you’ll collect the premium while you wait.
If the stock drops to $250 before expiry in January two years from now, you’ll be required to buy the 100 shares at that price. But you’ll keep the premium of $30 per share, so your net cost will be $220 per share. If shares never fall to $250, the option will expire worthless and you’ll keep the entire $3,000 premium.
In sum, as an alternative to buying 100 shares for $27,000, you can sell the put and lower your net cost to $220 a share (or a total of $22,000 for 100 shares, if the price falls to $250 per share). If the option expires worthless, you get to keep the $30 per share premium, which represents a 12% return on a $250 buy price.
It can be very attractive to sell puts on securities that you want to own. If Company A declines, you’ll be required to pay $25,000 in order to purchase the shares at $250. (Since you kept the $3,000 premium, your net cost will be $22,000). It’s important to keep in mind that your broker can force you to sell other holdings to buy this position if you don’t have available cash in your account.
Why would an investor write a put?
The two main reasons to write a put are (a) to earn premium income, and (b) to buy a desired stock at a price below the current market price.
What is the maximum loss possible when selling a put?
The maximum loss possible when selling or writing a put is equal to the strike price less the premium received. Here’s a simple example. Assume Company XYZ’s stock is trading at a price of $50, and you sell three-month puts with a strike price of $40 for a premium of $5.00. Let’s say you sold 10 put contracts, and since each put contract covers 100 shares, you collect $5,000 in option premium ($5.00 x 100 shares x 10 contracts). Just before the options expire, Company XYZ is reported to have engaged in massive fraud and is forced into bankruptcy, as a result of which the shares lose all value and trade near zero. The put buyer will exercise the option to “put” or sell the shares of Company XYZ at the strike price of $40, which means that you would be forced to buy these worthless shares at $40 each, for a total outlay of $40,000. However. since you had collected $5,000 in option premium upfront, your net loss is $35,000 ($40,000 less $5,000).
Is it better to buy a call or write a put?
It really depends on your risk tolerance and knowledge of options. Buying a call is a simple strategy, with your maximum loss limited to the call premium paid and your maximum gain theoretically unlimited. Writing a put, on the other hand, limits your maximum gain to the put premium received, while your maximum loss is much higher (and is equal to the put strike price less the premium received). Investors with lower risk appetite might prefer buying calls, while more savvy traders with high risk tolerance may prefer to write puts.
Is it advisable to write puts in volatile markets?
Since volatility is one of the main determinants of option price, in volatile markets, write puts with caution. You might receive higher premiums because of greater volatility, but if volatility continues to trend higher, your put may increase in price, meaning that if you want to close out the position, you will incur a loss. If you perceive the volatility increase to be temporary and expect it to trend lower, writing puts in such a market environment may still be a viable strategy.
The Bottom Line
The sale of put options can generate additional portfolio income while potentially gaining exposure to securities you would like to own but at a price below the current market price.