Content of the material
- What is a put option?
- Alternatives to Exercising a Put Option
- Profit and risk potential
- Example of Profit and Loss From a Put Option
- How a Put Option Works
- Benefits of Selling Put Options
- 1. Profit in a Sideways Market
- 2. Limited Risk
- 3. Potential for Appreciaton
- Puts vs. calls
- Is it Advisable to Write Puts in Volatile Markets?
- What Are the Various Selling Put Options?
- Things to know about selling puts to generate income
- What do I need to sell put options?
- Put Option Strike price
- Option Expiration date
- Chances of Profitability
- Example of a put option
- How do you close a put option?
- Put option risk profile
- Can Selling a Put Contract Produce Bonus Portfolio Income?
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).
Alternatives to Exercising a Put Option
The buyer of a put option does not need to hold an option until expiration. As the underlying stock price moves, the premium of the option will change to reflect the recent underlying price movements. The option buyer can sell their option and either minimize loss or realize a profit, depending on how the price of the option has changed since they bought it.
Similarly, the option writer can do the same thing. If the underlying price is above the strike price, they may do nothing. This is because the option may expire at no value, and this allows them to keep the whole premium. But if the underlying price is approaching or dropping below the strike price, then to avoid a big loss, the option writer may simply buy the option back (which gets them out of the position). The profit or loss is the difference between the premium collected and the premium paid to get out of the position.
Profit and risk potential
With cash-covered puts, the profit potential has 2 components: the option trade, and if the stock gets assigned. The most you can make from the option trade is the premium. If the stock is assigned and you are given ownership, your upside is potentially unlimited if the stock moves higher.
Cash-covered puts also have substantial risk because, if shares of the underlying stock fall below the strike price or even go all the way down to $0, you will still be obligated to buy shares at the original strike price. You can see how the risk involved with a cash-covered put differs from using a limit order to buy a stock.
Example of Profit and Loss From a Put Option
When you sell a put, you earn a profit (your collected premium payment) when the price of the underlying asset remains at or above the strike price of the option.
For example, if it is February 1 and XYZ is trading at $50, you may sell a put option with a strike price of $40 and an expiration date of June 30. Imagine you receive a premium payment of $85 for selling this put.
If the price of the stock remains above $40, you’ll earn a profit of $85, equal to the premium you received. Your profit does not change no matter how high the stock’s price rises.
If the stock price falls below $40 and the option holder exercises the option, you’ll lose $1 for each penny the stock drops below $40. Remember, each option covers 100 shares of XYZ, so a difference of one penny in the stock price means losing 100 pennies, or $1.
Recall the formula for calculating profit or loss when a put you sell is exercised:
((market price – strike price) * 100) + premium received = profit or loss
If the stock falls to $39, you’ll have to pay $40 per share when the option is exercised and can sell the shares on the open market for a loss of $100. Your overall loss is:
($39 – $40) * 100 + $85 = -$15
If the stock falls to $35, you’ll lose:
($35 – $40) * 100 + $85 = -$415
The more the share price decreases below the strike price, the greater your losses will be.
How a Put Option Works
A put option becomes more valuable as the price of the underlying stock or security decreases. Conversely, a put option loses its value as the price of the underlying stock increases. As a result, they are typically used for hedging purposes or to speculate on downside price action.
Investors often use put options in a risk management strategy known as a protective put, which is used as a form of investment insurance or hedge to ensure that losses in the underlying asset do not exceed a certain amount. In this strategy, the investor buys a put option to hedge downside risk in a stock held in the portfolio. If and when the option is exercised, the investor would sell the stock at the put’s strike price. If the investor does not hold the underlying stock and exercises a put option, this would create a short position in the stock.
Benefits of Selling Put Options
There are many advantages to selling puts.
1. 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.
2. 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.
3. Potential for Appreciaton
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.
Puts vs. calls
Put options are basically the opposite of call options, which give the option buyer the right to buy a particular security at a specified price any time prior to expiration. Here’s an easy way to remember the difference:
Puts = putting the security away from you (selling) Calls = calling the security toward you (buying)
Is it Advisable to Write Puts in Volatile Markets?
Since volatility is one of the main determinants of option price, in volatile markets, write puts with caution. You might receive higher premiums because of greater volatility, but if volatility continues to trend higher, then your put may increase in price, meaning that you will incur a loss if you want to close out the position. If you perceive the volatility increase to be temporary and expect it to trend lower, then writing puts in such a market environment may still be a viable strategy.
What Are the Various Selling Put Options?
Selling puts involves risk but can be profitable if properly done. Put option writers, also considered sellers, will sell put options hoping the contract will expire without any worth, allowing them to pocket a premium.
- Covered Puts: A covered put writing strategy is implemented when an investor is bearish on the asset. This provides coverage for the seller in the event that the obligated quantity of the asset is not available.
- Naked Puts: The naked put strategy is in play when the investor is bullish and the seller did not short the obligated amount of the asset at the time of the put option sale. The short put is considered naked. Writing naked puts can often be a smart way to acquire discounted stocks if a bullish investor is patient for an extended period of time.
- Put Spreads: The option strategy known as a put spread allows an equal number of put option contracts involving the same security but varying in strike prices and expiration dates, to be bought and sold at the same time. Potential profit and maximum loss caps are limited for the options trader in a put spread.
Things to know about selling puts to generate income
Like any investment, you’ll need to know some basic things about selling put options for income. In particular, it’s important to understand the mechanics, rights, obligations, and overall risk.
What do I need to sell put options?
To sell put options and generate weekly or monthly income, you will need to have collateral. Indeed, collateral will be in the form of cash or margin in your brokerage account. Remember, the put option seller agrees to buy equities in the future. So, the brokerage needs to have an ample amount of collateral to ensure the put seller can afford the purchase.
For example, if you want to sell 2 weekly put options a month on the SPY, you’ll need to be able to buy 200 shares of the SPY in your brokerage account. Conversely, if you want to sell 5 put options (and earn 5x the money), you’ll need to have enough cash or margin available to purchase 500 shares of the SPY in your brokerage account.
Put Option Strike price
The strike is the contracted price that you, the weekly (or monthly) put seller will buy the equity at (stock, or ETF), should the equity be below the strike at expiration. In Jimmy and Sally’s example, $10 is the strike price.
Option Expiration date
The expiration date is the last date the buyer can purchase the equity (called exercising) from you. Generally, put options expire on the 3rd Friday of each month. However, some put options expire weekly (on Fridays), and some expire on Mondays, Wednesdays, and Fridays. And, some options expire as much as 24-36 months into the future; those are called leaps options.
Chances of Profitability
Did you know that millions of options contracts trade daily? And did you know that a significant portion of those will expire worthless? In other words, the option sellers get to keep all the premiums while the buyers lose all their money. When trading put options, investors cannot overlook chances of profitability. Options-friendly brokerages will display the chances that your put option will be profitable. Option sellers who target 75-85% chances of profitability will more often than not, have the option expire workless, and they keep all the premium.
In the above example (left) I entered a sell order for a Microsoft put option with a $300 strike price, expiring May 6. For this, I could collect $10.85 in option premium or $1085 of income for the whole contract. But, take a look at the “profit probability” and “max return”. Notice how the “max return is just 49%? And the “profit probability” is 65%? Putting it differently, there’s a 35% chance this will go to zero.
But, 65% chances of profit isn’t enough. In fact, when it comes to chances of profit, it’s about the only time investors should be greedy. So, I tried a sell order for a Microsoft put option with a $285 strike, also expiring May 6. In this case, the premium is $5.80 but look at the “profit probability” and “max return”. And, there’s a 78% I’ll make a profit on this put option. And, if I sold the $280 strike, the profit probability goes up to 81%. So, the key is to take into consideration probabilities of profit.
Example of a put option
Let’s say that you thought that the share price of company ABC was going to fall from its current price of $30, and so you decide to open a put option with a strike price of $25. For stock options, each contract is worth the equivalent of 100 shares, but the price is usually quoted for one share.
When dealing options, there is always a premium to be paid. If the premium of this option was $1 per share, your total premium is $100.
If the price of ABC stock did fall, to a market price of $20, you could execute your right to sell the stock for the agreed strike price of $25 a share.
To calculate the profit, you subtract the market price from the strike price, giving you a profit of $5 per share. Since put options come in lots of 100 shares, you multiply that $5 per share profit by 100, which yields a gross profit of $500. After deducting the $100 premium, you would be left with a net profit of $400.
However, if the market had moved against you, you could let the option expire and your maximum loss would be cost of the initial $100 premium.
How do you close a put option?
If you sold the put to open the trade, then you will buy the put at the current market price to close it. If you originally bought the put option, then you will sell it to close the trade. An option's expiration or exercise will also close the trade for both parties involved.
Put option risk profile
Selling put options at a strike price that is below the current market value of the shares is a moderately more conservative strategy than buying shares of stock normally. Your downside risk is moderately reduced for two reasons:
- Your committed buy price is below the current market price
- You receive an option premium up front, regardless of what happens with the option or stock after that.
The net result of this is that you’re committing to an effective cost basis that is well below what you’d have to pay if you just bought the stock on the open market today. In the previous example, the market price was $30.50, and you committed yourself to a $28.57 cost basis.
However, as many put-selling tutorials will tell you, selling puts is “risky” because the downside risk outweighs the upside potential. The maximum rate of return you can get during this 3.5 months is a 5% return from put premiums. Your returns are therefore capped at 5%, or 18% annualized if you keep doing it. Your downside risk, however, is potentially very big. If the railroad were to suddenly go bankrupt and drop to $0/share, you’d be forced to buy them for $30/share, which would cost you $3,000. You’d at least get to keep your $143 premium to go out to a bar and buy drinks for your friends to cheer up.
Of course, if you simply had bought the railroad stock normally without any put-selling, you’d be in the same position, except slightly worse. If you own any stock and it goes bankrupt, you can lose your entire investment. And in that case, you wouldn’t even have the $143 premium. Your friends would have to buy you drinks at the bar.
That’s why this strategy necessitates buying high quality companies. I prefer companies that pay dividends, companies that have economic moats, companies with a differentiated product or service, and companies that have weathered recessions in the past. Put selling is moderately more conservative than normal stock buying, but you still must pick high quality companies to minimize your downside risk.
I see people teaching different put-selling strategies on more volatile, high-risk stocks with no intention to ever buy them, just to speculate with high premiums, and that’s not something I recommend for most people. I only suggest selling options on companies with a moat and a good balance sheet that you would actually like to own at the right price.
Put selling isn’t about hitting home runs. It’s about hitting a single or a double and getting to base almost every time. You either get paid a nice chunk of extra money for waiting to buy a stock you want at a lower price, or you get assigned to buy the stock at a low cost basis thanks to the option premium. It’s a tool that value investors can use to enter positions in great companies at great prices.
This chart shows the potential rate of returns of this option sale compared to buying the stock today at face value:
The horizontal axis gives a range of potential prices that the stock might be at during option expiration. The vertical axis indicates the rate of return over the lifetime of the option for each ending price, which was 3.5 months in this case. The pattern you see continues off the chart, from zero to infinity.
As you can see, upside potential is capped at 5% for the period (or 18% annualized), but your returns below that point are better than if you buy the stock outright.
Therefore, it’s a strategy not for when you’re extremely bullish, but for when you’re trying to buy the stock at a cheaper price, and when you’re trying to generate income and obtain some downside protection in an overvalued market.
Can Selling a Put Contract Produce Bonus Portfolio Income?
Option selling is like an art and risk management is critical. Choosing the most aggressive strike while not exceeding where the stock ultimately ends up on the date of expiration is often compared to playing the lottery. Bottom line, the sale of put options can be a wise method to produce bonus portfolio income and increase exposure to stocks you would like to own.
If you need help with selling a put contract, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.