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Selling or "writing" a put option allows an investor to potentially own the underlying security at a future date and a more favorable price. The sale of put options allows market players to gain bullish exposure with the added benefit of potentially owning the underlying security at both a future date and a price below the current market price.
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.
Buying a put option gives the owner the right to sell the underlying security at the option exercise price. This is considered to be a bearish bet: The owner makes money when the security goes down. Buying a call option is to be considered a bullish bet: The owner makes money when the security goes up.
Selling a call or put option flips over this directional logic in that the writer takes on an obligation to the counterparty when they're selling an option. The sale carries a commitment to honor the position. The seller is obligated to buy the position if it falls below the agreed strike price in the case of a put. The seller is obligated to deliver the shares if the position rises above the agreed strike price for a call.
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.
You should also enter trades only if the net price paid for the underlying security is attractive. This is the most important consideration in selling put options profitably in any market environment.
Other benefits of put selling can be exploited when this important pricing rule is satisfied. The ability to generate portfolio income sits at the top of the 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.
Suppose Company A is dazzling investors with increasing profits as the 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. You can buy 100 shares for $27,000 plus commissions and fees if you’re bullish about their prospects.
Another option would be for you to sell one January $250 put option that's expiring in two years for just $30. The option will expire on the third Friday of January two years later and it has an exercise price of $250. One option contract covers 100 shares, allowing you to collect $3,000 in options premium upfront less commission.
You’re agreeing to buy 100 shares of Company A for $250 by selling this option no later than two years in January. Company A shares are trading for $270 today so the put buyer isn’t going to sell you the shares for $250 because that's $20 below the current market price. You’ll collect the premium while you wait.
You’ll be required to buy the 100 shares at that price if the stock drops to $250 before expiry in January two years later but you’ll keep the premium of $30 per share. Your net cost would be $220 per share. The option would expire worthless and you’d keep the entire $3,000 premium if shares never fall to $250.
Your broker can force you to sell other holdings to cover your position if you don’t have available cash in your account.
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) as an alternative to buying 100 shares for $27,000 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. You'd be required to pay $25,000 to purchase the shares at $250 if Company A declines. Your net cost would be $22,000 because you kept the $3,000 premium.
The two main reasons to write a put are to earn premium income and to buy a desired stock at a price below the current market price.
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 you collect $5,000 in option premium ($5 × 100 shares × 10 contracts) because each put contract covers 100 shares. Company XYZ is reported to have engaged in massive fraud and is forced into bankruptcy just before the options expire. The shares lose all value and trade near zero as a result.
The put buyer will exercise the option to “put” or sell the shares of Company XYZ at the strike price of $40 so you'd be forced to buy these worthless shares at $40 each for a total outlay of $40,000. But your net loss is $35,000 ($40,000 less $5,000) because you collected $5,000 in option premium upfront.
Investors with lower risk tolerance might prefer buying calls. 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 is theoretically unlimited. Writing a put limits your maximum gain to the put premium received. Your maximum loss is much higher and is equal to the put strike price less the premium received.
Volatility is one of the main determinants of option price so write puts with caution in volatile markets. You might receive higher premiums because of greater volatility but your put may increase in price if volatility continues to trend higher. You'll incur a loss if you want to close out the position.
Writing puts in such a market environment may still be a viable strategy if you think the volatility increase will be temporary and you expect it to trend lower.
The sale of put options can generate additional portfolio income. It can potentially gain exposure to securities that you'd like to own but at a price below the current market price. But selling put options comes with risk. You could be stuck buying a worthless security in a worst-case scenario.
Disclosure: This article is not intended to provide investment advice. Investing in securities entails varying degrees of risk and can result in partial or total loss of principal. The trading strategies discussed in this article are complex and should not be undertaken by novice investors. Readers seeking to engage in such trading strategies should seek out extensive education on the topic.