Selling (also called writing) a put option allows an investor to potentially own the underlying security at both a future date and a more favorable price. In other words, the sale of put optionsallows market players to gain bullish exposure,with the added benefit of potentially owning the underlying securityat both a future date and 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 both a future date and 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 canbenefit your investment strategy, so let’s examine a typical trading scenario,as well as some potential risks and rewards.
Anequity option is a derivativeinstrumentthat acquires its value from the underlying security. Buying a call option gives the holderthe right to ownthe security at a predetermined price, known as the option exercise price.
Buying Vs. Selling Options
- Buying a call: You have the right to buy a securityat a predetermined price.
- Selling a call: You have an obligation to deliver the securityat a predetermined price to the option buyer if they exercise the option.
- Buying a put: You have the right to sell a securityat a predetermined price.
- Selling a put: You have an obligation to buy the securityat a predetermined price from the option buyer if they exercise the option.
Conversely, buying aput option gives the owner the right to sell the underlying securityat the option exercise price. Thus, buying a call option is a bullish bet—the ownermakesmoney when the securitygoes up. On the other hand, a put option is a bearish bet—the ownermakesmoney when the securitygoes down.
Selling a call or put option flips over this directionallogic. Moreimportantly, the writer takeson an obligation to the counterpartywhen selling an option; the sale carries acommitment to honortheposition if the buyer of the optiondecides to exercise their right to own the security outright.
Best Practices for Selling Put Options
Investors should sell put options only if they’re comfortable owning the underlying security at the predetermined price, because you’reassuming an obligation to buy ifthe counterparty chooses to exercise the option.
In addition, you should entertrades only if the net price paid for the underlying security is attractive. This is the most important consideration inselling put 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 becausethe seller keeps the entire premium ifthe sold put expires without exercise by the counterparty.Another key benefit is the opportunityto own the underlying securityat 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 reasonablevaluation for this company’s fast growth track. If you’re bullish about theirprospects, you canbuy 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 expireon the third Friday of January two years from now, and it has an exercise price of $250. Oneoption contract covers 100 shares, allowing you to collect $3,000 inoptions premium upfront (less commission).
By selling this option, you’reagreeingto 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 sharesfor $250, as that is $20 below the current market price. So you’ll collect the premium while youwait.
Ifthe stock drops to $250 before expiry in January two years from now, you’llbe required to buy the100 shares at that price. But you’llkeep 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’llkeep the entire $3,000 premium.
Your broker can force you to sell other holdingsto cover your position if you don’t have availablecash in your account.
In sum, asan 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 representsa 12% return on a $250 buy price.
It can be very attractive to sell puts on securitiesthat you want to own. If Company A declines, you’llbe required to pay $25,000 to purchase the shares at $250. (Since you kept the $3,000 premium, your net cost will be $22,000).
Why Would an Investor Write a Put?
The two main reasons to write a put are:
- To earn premium income
- 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. Let’s say you sold 10 put contracts, and since each put contract covers 100 shares, you collect $5,000 in option premium ($5 × 100 shares × 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 up front, your net loss is $35,000 ($40,000 less $5,000).
Is It Better to Buy a Call or Write a Put?
Investors with lower risk tolerance might prefer buying calls, while more savvy traders with high risk tolerance may prefer to write puts. 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).
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 you will incur a loss if you want to close out the position. If you perceive the volatility increase to be temporary and expect it to trend lower, writing puts in such a market environment still may be a viable strategy.
The Bottom Line
Thesale of put options can generateadditional portfolio income while potentially gaining exposure to securities that you would like to own but at a price below the current market price. As with any trading strategy, however, selling put options comes with risk. In a worst-case scenario, you could be stuck buying a worthless security.
