The concept of buying options is familiar to many traders. The best way to predict the market’s direction is to purchase a call or a put if you believe the stock market is going up or down.
There is a general rule of thumb: if the market stock price rises above your call strike or fall below your put price, you have made a profit. However, it is also critical to consider a few other factors when determining whether or not a trade is likely profitable. These factors include theta, which is the expiration date of the option.
Market directionality is evident in both strategies above. In one view, the market has to rise, while in the other, it has to fall. When the market remains unchanged or rises only slightly, a call expires worthless if the buyer cannot buy the stock back. Likewise, the company will lose money if it cannot buy them back from the company.
When it comes to buying options, there is little room for error. So, could you allow for some margin of error in your option? If the market moves too much, your option won’t be able to generate a profit, so you can take advantage of it. One strategy to consider is selling put options. This FintechZoom article will explain selling put, its main benefits, and risks.
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Selling Put Options
Selling put options is a strategy that is less familiar than buying them. Although some traders know put selling, they consider it extremely risky. You even hear some people say selling puts carries unlimited risk.
They refer specifically to naked puts when they refer to “dangerous” put selling. Naked put selling occurs when an option is sold directly without owning the stock involved (i.e., opting out of the stock). Selling puts rather than buying them is the first transaction in a put sell. Shorting occurs when you sell to open a position. Traders short put options in this case.
There are some similarities between the process of shorting stocks and the process of shorting bonds. Trading short stocks are about hoping the stock price will decrease. The trader holds a short bias toward the stock. To make money on the trade, the stock must go down. The situation could be more complex for put sellers.
Stocks sold at a discount to their current market value are considered neutral to bullish. There may be a contradiction between shorting and that. We’re shorting the option, so shouldn’t we expect the stock to decline if we short it? It would be great if its option premium went down.
Put selling is a means of neutralizing a stock’s price bullishness. You might think that’s the opposite of shorting. Don’t we want the stock to go down if we short an option? No. The team is hoping that the premium on its option will decrease shortly. Once the trade reaches zero, it means that the trade has been fully closed and successfully executed. Additionally, many brokers do have not the obligation charge an option contract fee when the premium falls below 0.10, making it advantageous to allow the premium to fall so low.
Selling puts example
The price of ABC shares is $50. You can buy the stock at the strike price of $50 put for a $5 premium, which expires six months after the purchase date. Buying 100 shares of a put contract costs $500 ($5 premium x 100 shares).
According to the chart below, the seller made a profit or paid off when selling the stock at different prices. A stock with a $1 drop in price below its strike price represents 100 shares, so every $1 drop increases the seller’s cost to $100.
Assuming that the higher strike price is at $45 per share and the strike price minus the premium received, the break-even point is at $45. Put sellers may earn up to $500 in profit from the sale of one share of stock. It is the put seller’s right to keep the entire premium if the stock stays above $50 per share. As the stock value declines, the put seller continues to lose money.
A put seller has limited upside and substantial downside compared to a put buyer. A put seller can earn $500 if a buyer exercises a put; however, they must purchase 100 shares of stock if the buyer exercises the put. You may lose the entire stock value if the underlying asset plummets to $0. As a result, any entire investment may be at risk.
For example, a put seller who buys a put at $50 x 100 shares might lose $5,000 if the underlying stock price falls to zero (see graph) if the strike price is paid at 50 cents per share.
Are there any risks associated with selling put options?
Is there an unlimited risk associated with put selling? No. Selling put options is equated with shorting stocks, which confuses that statement.
It is true – selling stocks short is risky. For example, if you sell MSFT stock at the 230 strikes, you are committing to purchase MSFT at a $230 share price. If the seller executes the contract before MSFT reaches $0, the seller loses all their money. If you receive the premium, you will lose approximately $23,000 (230 x 100 = $23,000).
There’s no doubt that’s a huge loss. However, it is highly unlikely that MSFT will fall to zero. If you close your position at a lower price, you will be able to mitigate your losses. The seller may also want to lock in profits before the stock reaches zero in addition to executing the contract well in advance.
A seller can suffer a maximum loss on a put sale, regardless of the strategy employed. The risk associated with selling naked calls, however, is unlimited.
When you sell puts far out of the money (near the current stock price), you can achieve a lot of padding. It allows quite a bit of movement in the stock price. Nevertheless, selling out-of-money puts is difficult. It isn’t easy to find high premiums to justify the trade.
Best Practices for Selling a Put Option
If the counterparty exercises the option, you’ll be obligated to buy stocks now the underlying security at the predetermined price. So, investors should only sell put options if they are comfortable owning them.
If you want to maximize your profits, you should trade only at attractive stock prices. The more profit a put option generates, regardless of the market situation, the more likely you will sell it at a profit.
When put selling fulfills this pricing rule, it can boast many advantages. First, the seller can generate a positive return on investment if the put is sold and the counterparty does not exercise it before it expires. Therefore, the seller keeps the entire premium. Another key benefit is you can also purchase the underlying security below its current market price.
Put Selling into Practice
The following example demonstrates prudent put selling. Suppose Company A has a revolutionary product that dazzles investors in terms of profits. Despite Company A’s rapid growth, its stock is currently $270, and its P/E ratio is extremely low. A 100-share purchase will cost you $27,000 plus fees and commissions if you are bullish about their prospects.
You could sell a January $250 put option for $30 and a January $250 put option that expires in two years. The exercise price of $250 represents the option’s expiration date on the third Friday of January after two years. You get the option premium upfront (less commission) for 100 shares in one contract.
To sell this option, you must commit to purchasing 100 shares of Company A for $250 no later than January 2, two years from now. Because the current market price of $270 is $20 below today’s price, the put option buyer will not sell you the shares for $250. As a result, you will collect your premium as you wait.
The 100 shares will have to be bought at $250 if the stock drops to that price before its expiration in January, two years from now. It will cost you $220 per share if you keep the premium of $30. A stock option expires worthless if it does not reach $250, and you keep the entire premium.
In summary, instead of paying $27,000 for 100 shares, you can save $220 per share by selling the put (or $22,000 at $250). In addition, a $250 buy price gets you a 12% return if the option expires worthless, which is $30 per share.
If you want to purchase securities, you may find it very attractive to sell puts on them. For example, to purchase Company A’s shares at $250, you must pay $25,000 if Company A declines. The net cost will be $22,000 since you kept the $3,000 premium. Depending on your broker, you may have to sell another holding first if you need more funds to buy this position.
Final Thoughts
Put selling is a strategy for collecting income. Traders are capped in their upside at the price at which they enter the trade. In contrast to holding stock long, a put seller will not profit from its upward movement. However, if you are patient enough to wait for the premiums to decline and find options far out of the money, this can be a rewarding trading strategy.
