You don’t have to let the market dictate what price you’ll pay for an awesome company. You can name your own price instead, and get paid to wait for the stock to dip to that level.
That’s what selling put options allows you to do.
When you sell a put option on a stock, you’re selling someone the right, but not the obligation, to make you buy 100 shares of a company at a certain price (called the “strike price”) before a certain date (called the “expiration date”) from them.
They’re paying you for this option to increase their own flexibility, and you’re getting paid to decrease your flexibility.
But by doing this in a smart way, you can get paid to do something you already wanted to do anyway- buy shares of a great company if they dip in price. Then you can hold them for as long or short of a time as you want to.
Table of Content
- What is Put Option And Selling a Put Option?
- How does Put Option Selling Work?
- Why sell a put option?
- What you can do by Selling A put Option?
- Benefits And Risk in Selling A put Option?
What is a put option?
A put option gives you the right, but not the obligation, to sell a stock at a specific price (known as the strike price) by a specific time at the option’s expiration. For this right, the put buyer pays the seller a sum of money called a premium. Unlike stocks, which can exist indefinitely, an option ends at expiration and then is settled, with some value remaining or with the option expiring completely worthless.
The major elements of a put option are the following....
- Strike price: The price at which you can sell the underlying stock
- Premium: The price of the option, for either buyer or seller
- Expiration: When the option expires and is settled
One option is called a contract, and each contract represents 100 shares of the underlying stock. Contracts are priced in terms of the value per share, rather than the total value of the contract. For instance, if the exchange prices an option at $1.50, then the cost to buy the contract is $150, or (100 shares*1 contract* $1.50).
How does a put option work?
Put options are in the money when the stock price is below the strike price at expiration. The put owner may exercise the option, selling the stock at the strike price. Or the owner can sell the put option to another buyer prior to expiration at fair market value.
A put owner profits when the premium paid is lower than the difference between the strike price and stock price at option expiration. Imagine a trader purchased a put option for a premium of $0.80 with a strike price of $30 and the stock is $25 at expiration. The option is worth $5 and the trader has made a profit of $4.20.
If the stock price is above the strike price at expiration, the put is out of the money and expires worthless. The put seller keeps any premium received for the option.
Why sell a put option?
If you’re looking to trade options, you can sell them as well as buy them. Here are the advantages of selling puts. The payoff for put sellers is exactly the reverse of those for buyers. Sellers expect the stock to stay flat or rise above the strike price, making the put worthless.
Using the example as, imagine that stock WXY is trading at $40 per share. You can sell a put on the stock with a $40 strike price for $3 with an expiration in six months. One contract gives you $300, or (100 shares*1 contract*$3).
- For a stock price above $40 per share, the option expires worthless and the put seller keeps the full value of the premium, $300.
- Between $37 and $40, the put is in the money and the put seller earns some of the premium, but not the full amount.
- Below $37, the put seller begins to lose money beyond the $300 premium received.
The appeal of selling puts is that you receive cash upfront and 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. If the stock falls far enough in value you will receive a margin call, requiring you to put more cash in your account.
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.
By selling put options, you can.......
- Generate double-digit income and returns even in a flat, bearish, or overvalued market. You don’t need a strong bull market or fast business growth for great investment returns.
- Give your portfolio 10% or so downside protection in the event of a market crash. In other words, if the market drops 25%, your equity positions would likely only drop 15%.
- Enter stock positions at exactly the price you want, and keep your cost basis low. Buy during dips and get a better value than the current market price offers.
Like any tool, there’s an appropriate time and place to sell put options, and other times where it’s not an ideal tactic.
When used correctly, this is a sophisticated and under used way of entering equity positions, and this article provides a detailed overview with examples on how to do it.
Benefits of Selling Put Options
There are many advantages to selling puts.
- 1. Limited Risk
Many options strategies have theoretically unlimited risk, which makes them a scary proposition to everyday investors. However, like covered calls and a few other options strategies, selling puts has limited risk. If the market price of a stock or ETF drops to $0, the absolute most you can lose from selling a put option is....
(100*number of contracts*strike price)–premium received=worst possible loss
This is still a notable risk, but it’s comparable to the risk you assume when you buy 100 shares of the underlying security at market value. Unlike some other derivative investments, you can never lose more than the value of the shares you agree to buy.
- 2. Potential for Appreciation
The failure case for selling a put option is if the option buyer exercises the option and sells shares to you above their market value.
Once assigned, though, you can simply hold onto the shares. If you already wanted to include those shares in your portfolio as part of your investment strategy, there’s nothing forcing you to immediately sell them as part of fulfilling the contract.
If you wanted to own the stock for the long term anyway, you can keep it in your portfolio and wait for its price to appreciate. In the end, you could sell the shares for a profit, recouping your losses on the option.
- 3. Profit in a Sideways Market
If you buy shares in a company, you only turn a profit when those shares increase in value. One advantage of selling puts is that investors can use the strategy to earn a profit when the price of a stock doesn’t rise or fall.
With a put, you receive the premium when you sell the contract. So long as the strike price of the contract is below the current market price, the buyer likely won’t exercise the option if the price of the underlying security holds steady, remaining above the strike price.
This gives investors more choices for earning a return than simply buying shares.
Risks of Selling Put Options
Before you start selling puts, you need to be aware of the potential risks and drawbacks.
- 1. Limited Potential Profits
When you sell a put, the buyer pays you an option premium. The payment you receive is the maximum profit you can earn from the transaction. Other options strategies and investing strategies have much higher profit potential than selling puts.
Typically, the maximum potential profit from selling a put is much lower than the potential loss if the stock falls to a lower price. Investors need to keep the mix of risk and reward in mind when selling puts.
- 2. Leverage Increases Potential Losses
Options strategies let investors leverage their portfolios, gaining control over a large number of shares at a low price.
Most options contracts involve 100 shares of the underlying stock or ETF but cost much less than 100 shares on their own. Leveraging your portfolio means higher gains when you turn a profit, but also leads to larger losses when your plans fail to pan out.
A $1 change in a stock’s price can equate to $100 in additional losses on a single put option if the buyer exercises it, so it’s important for investors to be prepared for potentially large losses.
- 3. Margin Calls
One major risk related to the leverage involved in using puts is the risk of a margin call.
If you sell put options but don’t have the funds in your account to cover the cost if the option buyer were to exercise them, your brokerage will want to know you can afford to pay for the shares you’ll need to buy. They’ll keep track of the liability created by the put options you’ve sold.
However, there are limits on how much money a broker will let you borrow. The amount is related to the value of your account.
If the market drops and you wind up with a large potential liability due to puts you’ve sold, your broker might make a margin call, forcing you to put more money in the account to cover your liabilities.
If you can’t come up with the cash to meet the call, your broker may force you to sell other investments, even for a loss, to cover the liability.