Selling Puts – Selling Put Options for Income to Benefit in Any Market
Selling puts is also called writing a put option. It allows an investor to potentially own the underlying security at a future date and a potentially more favorable price. In other words, selling put options allows market players to gain bullish exposure. There is the added benefit of potentially owning the underlying security at a future date at a price below the current market price.
Selling puts can generate immediate portfolio income to the seller. The seller can keep the premium if the sold put is not exercised by the counterparty and it expires out-of-the-money. An investor can sell put options in securities that he wants to own anyway. This will increase the chances of being profitable. However, 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.
Selling Puts vs Call Options
A quick primer on options may be helpful in understanding how writing options and selling puts can benefit your investment strategy. Let’s review a typical trading scenario, as well as some potential risks and rewards.
Selling a call or put option flips over this logic. Also, 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.
Best Practices for Selling Put Options
Investors should only sell put options if they’re comfortable owning the underlying security at the predetermined price. This is 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. This is 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.
An investor would choose to sell a naked put option if their outlook was that the security was going to rise. The buyer, on the other hand, would have a bearish outlook. The purchaser of a put option pays a premium to the writer. In return, the buyer has the right to sell the shares at an agreed-upon price in the event that the price heads lower. If the price rises above the strike price, the buyer would not exercise the put option. This is because it would be more profitable to sell at a higher price on the market. The premium would be kept by the seller if the price closed above the agreed-upon strike price. This is why an investor might choose to use this type of strategy. If the price goes up, the seller wins. If the price goes down, the buyer wins.
Let’s look at a put option on Microsoft (MSFT). The writer or seller of MSFT Jan18 67.50 Put will receive a $7.50 premium fee from a put buyer. If MSFT’s market price is higher than the strike price of $67.50 by January 18, 2018, the put buyer will choose not to exercise their right to sell at $67.50 since they can sell at a higher price on the market. The buyer’s maximum loss is, therefore, the premium paid of $7.50, which is the seller’s payoff. If the market price falls below the strike price, the put seller is obligated to buy MSFT shares from the put buyer at the higher strike price since the put buyer will exercise their right to sell at $67.50.
Selling Puts in Practice
Let’s look at an example of selling puts. Suppose shares in Company A are attracting investors with increasing profits as a result of a new, revolutionary product. The 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 over time (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 ask you to buy the shares for $250. So you’ll collect the premium while you wait.
What if the Stock Drops?
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 as 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 $22,000 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.
Selling Puts – Example Using Commodities
Put options are used for commodities as well as stocks. Commodities are tangible things like gold, oil, and agricultural products, including wheat, corn, and pork bellies. Unlike stocks, commodities aren’t bought and sold outright. No one purchases and takes ownership of a “pork belly.”
Instead, commodities are bought as futures contracts. These contracts are hazardous because they can expose you to unlimited losses. Why? Unlike stocks, you can’t buy just one ounce of gold. A single gold contract is worth 100 ounces of gold. If gold loses $1 an ounce the day after you bought your contract, you’ve just lost $100. Since the contract is in the future, you could lose hundreds or thousands of dollars by the time the contract comes due.
Put options are used in commodities trading because they are a lower risk way to get involved in these highly risky commodities futures contracts. In commodities, a put option gives you the option to sell a futures contract on the underlying commodity. When you buy a put option, your risk is limited to the price you pay for the put option (premium) plus any commissions and fees. Even with the reduced risk, most traders don’t exercise the put option. Instead, they close it before it expires. They just use it for insurance to protect their losses.
Selling Puts for Income
The appeal of selling puts is that you receive cash upfront. Also, you may not ever have to buy the stock at the strike price. If the stock rises above the strike by expiration, you’ll make money. But you won’t be able to multiply your money as you would by buying puts. As a put seller, your gain is capped at the premium you receive upfront.
Selling a put seems like a low-risk proposition, and it often is. But, if the stock really plummets, then you’ll be on the hook to buy it at the much higher strike price. And you’ll need the money in your brokerage account to do that. Typically investors keep enough cash, or at least enough margin capacity, in their account to cover the cost of stock, if the stock is put to them. For example, if the stock fell from $40 to $20, a put seller would have a net loss of $1,700, or the $2,000 value of the option minus the $300 premium received. But done prudently, selling puts can be an effective strategy to generate cash, especially on stocks that you wouldn’t mind owning if they fell.
The Bottom Line
The sale of put options can generate additional portfolio income. You potentially gain exposure to securities you would like to own anyway, but at a price below the current market price. However, while selling options can be an income-generating strategy it also comes with potentially unlimited risk. Especially if the underlying asset moves against your bet significantly. Therefore, selling naked options should only be done with extreme caution.
Another reason why investors may sell options is to incorporate them into other types of options strategies. For example, if an investor wishes to sell out of their position in a stock when the price rises above a certain level, they can incorporate what is known as a covered call strategy. Many advanced options strategies will likely require an investor to sell options.
Selling puts is a popular strategy used to generate income on an underlying product. Particularly when the trader has a neutral to bullish outlook and a bearish volatility outlook. Selling a put can be used instead of placing a buy limit order when a trader is looking to establish a long stock position at a specified price. The benefit is that the premium can potentially reduce the cost basis of the long shares if assigned. However, like a buy limit order getting the long shares of stock is not guaranteed.
Up Next: Day Trading For Beginners – What Is A Day Trader
Day trading is simply buying a stock or security, then, quickly selling or closing out the position. Usually, the position is closed within a single trading day. Ideally, a day trader wants to “cash-out” by the end of each trading day. They want no open positions to avoid the risk of losses by holding security overnight. Day trading is not for everyone and carries significant risks. It requires an in-depth understanding of how the markets work and various strategies for profiting in the short term. Short term profits require a very different approach compared to traditional long term, buy and hold investment strategies.