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 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 a put option allows an investor to potentially own the underlying security at 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 they want to own anyway will increase their chances of being profitable.
- The writer of a put option will lose money on the trade if the price of the underlying security drops before expiration and if the option finishes in the money.
Call Options vs. Put Options
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 aput option gives the owner the right to sell the underlying securityat the option exercise price. This is considered to be abearishbet: The ownermakesmoney when the securitygoes down. Buying a call option is to be considered abullishbet: The ownermakesmoney when the securitygoes up.
Selling a call or put optionflips over this directionallogic in that the writer takes on an obligation to the counterpartywhen they're selling an option. The sale carries acommitment 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.
Buying Vs. Selling Options
- Buying a call: You have the right to buy a securityat a predetermined price.
- Selling a call: You must 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 must buy the securityat 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 because you’reassuming an obligation to buy ifthe counterparty chooses to exercise the option.
You should also 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 when this important pricing rule is satisfied. The ability to generate portfolio income sits at the top of the 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
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 reasonablevaluation for this company’s fast growth track. You canbuy 100 shares for $27,000 plus commissions and fees if you’re bullish about theirprospects.
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 expireon the third Friday of January two years later and it has an exercise price of $250. Oneoption contract covers 100 shares, allowing you to collect $3,000 inoptions premium upfront less commission.
You’reagreeingto 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 sharesfor $250 because that's $20 below the current market price. You’ll collect the premium while youwait.
You’llbe required to buy the100 shares at that price ifthe stock drops to $250 before expiry in January two years later but you’llkeep 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 holdingsto cover your position if you don’t have availablecash 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) asan alternative to buying 100 shares for $27,000 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. 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.
Why Would an Investor Write a Put?
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.
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 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.
Is It Better to Buy a Call or Write a Put?
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.
Is It Advisable to Write Puts in Volatile Markets?
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 Bottom Line
Thesale of put options can generateadditional 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.
