Options contracts allow buyers and sellers to exchange the right to acquire shares at a predetermined price. Options trading is difficult, but it’s worth the effort since it allows investors to earn from making a variety of forecasts about the future price movement of a company, even if those predictions wouldn’t be profitable if they merely owned the stock.
Put options in particular allow traders to purchase and sell the right to sell a stock at a certain price. As part of their trading strategy, some investors elect to sell put options.
Basic Terms to Know
- Puts can be sold or written. If you sell or “write” a put option, you give the buyer the right to sell you a certain number of shares of stock at a certain price. You, as the put’s seller, must buy the shares from the put’s buyer at the strike price if the put’s buyer exercises the option.
- Obtain a Put. To purchase a put is to pay a premium in exchange for the right to sell a stock to another party at a predetermined price. An individual who purchases a put has the option to sell their shares to the seller at the strike price.
- Target Cost. The striking price is the price at which the underlying stock can be purchased or sold under the terms of the option.
- Term of Validity Ending. When an option’s expiration date arrives, the corresponding option contract no longer has any legal or economic force. Prior to the option’s expiration date, the buyer must make the decision to exercise the option.
What is a Put Option?
The owner of a put option is obligated to sell the underlying stock or ETF at the option’s strike price but is not obligated to do so. The typical option size is 100 shares of stock.
You may, for instance, sell someone a put option on 100 shares of XYZ stock at a strike price of $50 per share, with the option’s expiration date set for July 31. The option buyer has until July 31 to exercise their right to sell you 100 shares of XYZ at $50 per share.
When the stock price of XYZ falls below $50, the option buyer is likely to put their money where their mouth is and make use of their purchase. As a result, they will be able to acquire the stock on the open market and promptly resell it for a profit.
The premium paid to put sellers by the put buyer is the payment for the seller’s risk. If the put option buyer doesn’t use the option, the seller still gets to keep the premium.
Why Would a Trader Sell Put Options?
There are a few scenarios in which investors would choose to sell put options.
Earn Money
Selling put options is only one way that investors may make money through options trading. Put options to get a premium from the buyer. If the buyer decides not to exercise the option, you still get to retain the premium. With a higher premium comes a higher payout.
Your gain is the whole amount of the premium if the buyer does not exercise the option. For a calculation of your gain or loss should the buyer decide to exercise the option, consider:
- ((market price – strike price) * 100) + premium received = profit or loss
When a certain price is reached, buy shares.
Some investors, especially those with a long-term horizon, do their homework to determine the fair value of individual stocks and the price at which they are willing to acquire those equities. In the event that a stock falls below a certain price, those investors can acquire shares at a discount by selling put options.
If XYZ is now selling for $50 and you know you want to get in when the price drops to $40 or less, you may sell put options with a $40 strike price. If the price of the stock drops below $40, the option holder is likely to exercise the option, requiring you to purchase the shares for $40 apiece.
Selling puts allows you to generate revenue until the share price hits your target purchase price. However, if the market drops much below your goal price, you may end up paying too much for the stock.
If the stock price in the preceding example dropped to $30, and the option holder decided to exercise the option, the buyer would still have to pay $40 a share, or 10% more than the stock was worth on the open market. Holding on for the long haul, however, still affords the opportunity to profit from the stock’s eventual appreciation.
Advantages of Selling Put Options
Selling puts may bring in a lot of extra cash, for a variety of reasons.
1. Profit in a Down Market
For an investor to make money on a stock purchase, the value of their holdings must rise. One benefit of selling puts is that it allows investors to make money even if the stock price of their investment doesn’t move in either direction.
When you sell a put option, you keep the premium. If the underlying asset’s price stays the same and is higher than the strike price, the buyer of the option contract is unlikely to exercise their right to purchase the security at the lower strike price. This provides alternate avenues for return for investors beyond the traditional stock market.
2. Risk Reduction
The theoretically infinite danger of many options techniques is enough to put off the average investor. The risk associated with selling puts is low, similar to that of covered calls and other limited-risk options strategies. When selling a put option, the maximum you may lose is if the market price of the underlying stock or ETF declines to zero.
- (100 * number of contracts * strike price) – premium received = worst possible loss
Still a considerable risk, but about on par with purchasing 100 shares of the underlying securities at market price. As opposed to other derivative investments, your maximum loss will never exceed the purchase price of the shares you commit to.
3. Possibility of Appreciation
If the option buyer exercises the option and sells shares to you at a price higher than the current market price, the sale of the put option was a failure.
Shares can be kept indefinitely after assignment. There is no requirement that you immediately sell the shares as part of satisfying the contract if you planned to put them in your portfolio as an investment.
You can hold on to the stock in your portfolio and wait for it to rise in value if you always intended to hold onto it anyhow. You might be able to recover some or all of your option-related losses if you sell the stock at a later date.
The Dangers of Selling Put Options
You should know the benefits and downsides of selling puts before you begin.
1. Leverage raises the possibility of loss.
Through the use of options methods, investors may leverage their holdings and acquire a disproportionately large number of shares at a relatively cheap cost.
Many options contracts are denominated in terms of 100 shares of the underlying stock or ETF, yet a single share of the underlying security typically costs far less than the option premium. Leveraging your portfolio increases your profits when things go well but magnifies your losses when they don’t.
Investors should be prepared for big losses because a $1 change in a stock’s price might result in $100 in further losses on a single put option if the buyer exercises it.
2. Calls for Margin
The possibility of a margin call is a significant danger when utilizing puts because of the leverage involved. In the event that you sell, put options and the buyer exercises those options, your brokerage will demand assurances that you have the means to purchase the requisite number of shares. The put options you’ve sold will generate a liability, which will be tracked for you.
However, there is often a maximum loan amount that can be approved by a broker. This sum is proportional to the total money in your account.
Your broker may issue a margin call if the market lowers and your potential liability rises sharply as a result of sold put options. In this case, you would need to deposit extra funds into the account to cover the shortfall.
If you don’t have the money on hand to pay the call, your broker may sell other holdings, even at a loss, to satisfy the debt.
3. Profit Potential Is Limited
The premium is paid to the seller of a put option. What you’ve been paid is the most you can reasonably expect to make on this deal. The profit potential of selling puts is quite low in comparison to other options methods and investment strategies.
A put seller’s maximum gain is often significantly smaller than the buyer’s loss if the stock drops in price. When selling puts, investors must weigh the potential loss against the potential gain.
How to Make Money Selling Put Options
Opening a brokerage account is the first step if you’ve determined that selling put options is the way to go. There is no shortage of brokerages from which to choose if you choose to engage in options trading, so it is important to examine things like costs and user interface before settling on a firm.
The next step is to decide what kind of security you’d like to sell puts on. In general, put options on equities and ETFs are tradeable. The security you decide to invest in must give you confidence that its value will be steady or even rise.
Keep in mind that you get money if the price of the underlying asset goes up or remains the same, and you lose money if it goes down below the option’s strike price. When selling puts, the premiums you may demand are larger on volatile equities, increasing your potential earnings.
Next, decide on a strike price and an end date for your option once you’ve settled on security. Larger strike prices and later expiration dates typically result in higher premiums. The less the stock’s value must fall for the buyer to make money, the higher the option’s strike price.
Similarly, the longer the time period between the option’s sale and its expiration, the more time the stock price has to decline below the option’s strike price. Premiums paid to put sellers reflect the extra risk they are taking.
After deciding on security, strike price, and expiration date, you can then place the sell order using your brokerage account.
Bottom Line
Options allow investors to increase their portfolio’s leverage and get returns in circumstances where direct ownership of a company’s stock would not. While selling puts might be an easy way to generate money from a portfolio, safer strategies like selling covered calls are also available. One of the greatest methods to learn about trading options is, to begin with, these tactics, which involve less risk.
