Selling Puts: How to Write a Put Option


You may not think that options trading has much to do with long-term investing — and for the most part, you’d be right. Many conventional options trades, such as buying call options or put options, are generally geared toward short-term speculation.

Selling puts, when done right, is an exception. This unusual and oft-overlooked option trade can pair well with buy-and-hold investing strategies.

What is put selling?

Put selling means entering into a contract with a put buyer in which the buyer pays you a small amount of money (a “premium”) in exchange for the right, but not the obligation, to sell an underlying stock to you at a specific “strike price,” on or before a specific “expiration date.” Each contract typically controls 100 shares of the underlying stock.

As the seller (or “writer,” in options-trading parlance), you are obligated to buy the underlying shares from the put buyer, if they exercise the option. You don’t have to do anything if they don’t exercise it.

The buyer is likely to exercise the option if it’s “in the money” — that is, if the market price of the underlying stock is lower than the strike price. In that case, they can sell the shares to you for more than they’re worth on the market.

This allows them to make an instant profit by buying the shares at the market price, and selling them to you at the higher strike price. You, on the other hand, get stuck buying shares whose resale price is lower than the amount you’re paying for them — but as we’ll discuss later, that isn’t always a bad thing.

If the option is “out of the money” — if the market price of the underlying stock stays higher than the strike price until expiration — then the put is worthless for the buyer, and they will likely let it expire without exercising it. In that case, you as the seller get to keep the premium the buyer paid you without taking any further action.

Because of these incentives, put selling is implicitly a bet that the underlying stock will rise in price before the expiration date, while put buying is implicitly a bet that it will fall before the expiration date.

Advertisement

NerdWallet rating 
NerdWallet rating 
NerdWallet rating 

Fees 

$0

per online equity trade

Promotion 

None

no promotion available at this time

Promotion 

None

no promotion available at this time

Promotion 

Get up to 75 free fractional shares (valued up to $3,000)

when you open and fund an account with Webull.

What are the risks of selling puts?

The main risk of put selling is that you could be forced to spend a bunch of money buying a stock for more than its market price — although we’ll see in a moment how that isn’t necessarily an unwanted outcome for all traders.

The absolute worst-case scenario for a put sale is that you are forced to buy a stock whose market price goes to zero, in which case you’ll never be able to re-sell it at all, and you’ll have to accept the complete loss of the money you paid to buy it at the strike price.

Consider, for example, a fictional stock called ZYX Corporation whose shares are currently trading at $50. Suppose that you sell ZYX puts with a strike price of $50 for a premium of $5, so one contract (controlling 100 shares) costs $500 for put buyers.

The graph below shows your profit or loss, depending on ZYX’s market price on the expiration date of the option. Your maximum profit is $500 (if the option expires worthless), while your maximum loss is $4,500 (if it is exercised, and you are forced to buy 100 shares of the stock for $50 per share, minus the $5 premium you received per share, when it has a market price of $0).

If you sell a lot of put options, you may also want to keep an eye on market volatility levels, as measured by benchmarks like the VIX volatility index. Volatility is a factor in option pricing, and low volatility can push down the premiums that put sellers can collect.

How do investors use put selling?

Some investors sell puts to generate income from a stock that they think will rise in the future. This can be an especially effective strategy when most investors think the stock will fall in the near-future, and when market volatility is high — as negative sentiment and high volatility both increase the premiums that sellers can demand from put buyers.

But there’s another use of put selling that can complement buy-and-hold strategies like value investing: to buy stocks for less than you believe they’re truly worth, or get paid for trying.

Let’s revisit our example: suppose ZYX Corp. has a PE ratio that is 50% lower than its competitors. Based on this, you believe that ZYX is trading at a 50% discount — that its shares should be worth $100, rather than $50.

In that case, you might sell a put option with a strike price of $50 and a premium of $5, and be happy even if the buyer exercises the option and sells you the shares at the strike price.

In such a scenario, you’d be on the “losing” end of the option trade, and your ZYX shares might initially be worth less than you paid for them — but you’d still be buying ZYX for less than you believe it’s worth in the long term.

If your theory is correct, and ZYX shares rise to $100 in the months or years ahead, you’d still be able to sell your shares for $10,000, with the satisfaction that you only bought them for $4,500.

If the put buyer doesn’t exercise your option, then you wouldn’t get the stock — but you’d still be happy to receive $500 for doing nothing. (That’s the “or get paid for trying” part.)

Track your finances all in one place.

Find ways to save more by tracking your income and net worth on NerdWallet.

How to get started selling puts

To get started selling puts, you’ll need a brokerage account that supports options. Some brokers require investors to pass a test or maintain a minimum balance in order to trade options.

In order to ensure that put sellers can fulfill their obligation to buy the underlying stock upon exercise, many brokers also require investors to have a margin account with a certain level of buying power in order to sell puts.

Once you’ve opened an account and gotten approved to sell puts, it’s worth familiarizing yourself with options ticker symbols — which can be daunting to the initiated.

Options symbols are long strings of letters and numbers that indicate the underlying stock, expiration date, type and strike price of the contract.

For example, a put option on Apple (AAPL) with a strike price of $155.00 and an expiration date of June 21, 2024 would be listed as “AAPL240621P00155000.”

In order, “AAPL” represents the underlying stock ticker symbol, “24” represents the year 2024, “06” represents June, “21” represents the 21st day of June, “P” stands for put option, and “00155000” means a strike price of $155.00. (In options symbols, prices are always given in an eight-digit format, where the first digit represents tens of thousands and the last represents tenths of a cent.)

Options trading isn’t for everyone — and research suggests that most people who try it end up with losses .

But if you understand the risks of selling puts, and you’re interested in buy-and-hold investing strategies on undervalued stocks, put selling can sometimes serve as a way to buy stocks at a discount, or make some cash while attempting to do so.



Source link

About The Author

Scroll to Top