Selling Index Puts Explained

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When does one sell a put option, and when does one sell a call option?

The incorporation of options into all types of investment strategies has quickly grown in popularity among individual investors. For beginner traders, one of the main questions that arise is why traders would wish to sell options rather than to buy them. The selling of options confuses many investors because the obligations, risks, and payoffs involved are different from those of the standard long option.

Key Takeaways

  • Selling options can be a consistent way to generate excess income for a trader, but writing naked options can also be extremely risky if the market moves against you.
  • Writing naked calls or puts can return the entire premium collected by the seller of the option, but only if the contract expires worthless.
  • Covered call writing is another options selling strategy that involves selling options against an existing long position.

Overview

In options terminology, “writing” is the same as selling an option, and “naked” refers to strategies in which the underlying security is not owned and options are written against this phantom security position. The naked strategy is aggressive and higher risk but can be used to generate income as part of a diversified portfolio. However, if not used properly, a naked call position can have disastrous consequences since a security can theoretically rise to infinity.

To understand why an investor would choose to sell an option, you must first understand what type of option it is that he or she is selling, and what kind of payoff he or she is expecting to make when the price of the underlying asset moves in the desired direction.

When Should I Sell A Put Option Vs A Call Option?

Selling Puts

An investor would choose to sell a naked put option if her outlook on the underlying security was that it was going to rise, as opposed to a put buyer whose outlook is bearish. The purchaser of a put option pays a premium to the writer (seller) for the right to sell the shares at an agreed upon price in the event that the price heads lower. If the price hikes above the strike price, the buyer would not exercise the put option since it would be more profitable to sell at the higher price on the market. Since the premium would be kept by the seller if the price closed above the agreed-upon strike price, it is easy to see why an investor would choose to use this type of strategy.

Example

Let’s look at a put option on Microsoft (MSFT). The writer or seller of MSFT Jan18 67.50 Put will receive a $7.50 premium fee from a put buyer. If MSFT’s market price is higher than the strike price of $67.50 by January 18, 2020, the put buyer will choose not to exercise his right to sell at $67.50 since he can sell at a higher price on the market. The buyer’s maximum loss is, therefore, the premium paid of $7.50, which is the seller’s payoff. If the market price falls below the strike price, the put seller is obligated to buy MSFT shares from the put buyer at the higher strike price since the put buyer will exercise his right to sell at $67.50.

Selling Calls

An investor would choose to sell a naked call option if his outlook on a specific asset was that it was going to fall, as opposed to the bullish outlook of a call buyer. The purchaser of a call option pays a premium to the writer for the right to buy the underlying at an agreed upon price in the event that the price of the asset is above the strike price. In this case, the option seller would get to keep the premium if the price closed below the strike price.

Example

The seller of MSFT Jan18 70.00 Call will receive a premium of $6.20 from the call buyer. In the event that the market price of MSFT drops below $70.00, the buyer will not exercise the call option and the seller’s payoff will be $6.20. If MSFT’s market price rises above $70.00, however, the call seller is obligated to sell MSFT shares to the call buyer at the lower strike price, since it is likely that the call buyer will exercise his option to buy the shares at $70.00.

Writing Covered Calls

A covered call refers to selling call options, but not naked. Instead, the call writer already owns the equivalent amount of the underlying security in his or her portfolio. To execute a covered call, an investor holding a long position in an asset then sells call options on that same asset to generate an income stream. The investor’s long position in the asset is the “cover” because it means the seller can deliver the shares if the buyer of the call option chooses to exercise. If the investor simultaneously buys stock and writes call options against that stock position, it is known as a “buy-write” transaction.

Covered call strategies can be useful for generating profits in flat markets and, in some scenarios, they can provide higher returns with lower risk than their underlying investments

The Bottom Line

Selling options can be an income-generating strategy, but also come with potentially unlimited risk if the underlying moves against your bet significantly. Therefore, selling naked options should only be done with extreme caution.

Another reason why investors may sell options is to incorporate them into other types of option strategies. For example, if an investor wishes to sell out of his or her position in a stock when the price rises above a certain level, he or she can incorporate what is known as a covered call strategy. Many advanced options strategies such as iron condor, bull call spread, bull put spread, and iron butterfly will likely require an investor to sell options.

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Put Option

Definition:
A put option is an option contract in which the holder (buyer) has the right (but not the obligation) to sell a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).

For the writer (seller) of a put option, it represents an obligation to buy the underlying security at the strike price if the option is exercised. The put option writer is paid a premium for taking on the risk associated with the obligation.

For stock options, each contract covers 100 shares.

Buying Put Options

Put buying is the simplest way to trade put options. When the options trader is bearish on particular security, he can purchase put options to profit from a slide in asset price. The price of the asset must move significantly below the strike price of the put options before the option expiration date for this strategy to be profitable.

A Simplified Example

Suppose the stock of XYZ company is trading at $40. A put option contract with a strike price of $40 expiring in a month’s time is being priced at $2. You strongly believe that XYZ stock will drop sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 XYZ put option covering 100 shares.

Say you were spot on and the price of XYZ stock plunges to $30 after the company reported weak earnings and lowered its earnings guidance for the next quarter. With this crash in the underlying stock price, your put buying strategy will result in a profit of $800.

Let’s take a look at how we obtain this figure.

If you were to exercise your put option after earnings, you invoke your right to sell 100 shares of XYZ stock at $40 each. Although you don’t own any share of XYZ company at this time, you can easily go to the open market to buy 100 shares at only $30 a share and sell them immediately for $40 per share. This gives you a profit of $10 per share. Since each put option contract covers 100 shares, the total amount you will receive from the exercise is $1000. As you had paid $200 to purchase this put option, your net profit for the entire trade is $800.

This strategy of trading put option is known as the long put strategy. See our long put strategy article for a more detailed explanation as well as formulae for calculating maximum profit, maximum loss and breakeven points.

Protective Puts

Investors also buy put options when they wish to protect an existing long stock position. Put options employed in this manner are also known as protective puts. Entire portfolio of stocks can also be protected using index puts.

Selling Put Options

Instead of purchasing put options, one can also sell (write) them for a profit. Put option writers, also known as sellers, sell put options with the hope that they expire worthless so that they can pocket the premiums. Selling puts, or put writing, involves more risk but can be profitable if done properly.

Covered Puts

The written put option is covered if the put option writer is also short the obligated quantity of the underlying security. The covered put writing strategy is employed when the investor is bearish on the underlying.

Naked Puts

The short put is naked if the put option writer did not short the obligated quantity of the underlying security when the put option is sold. The naked put writing strategy is used when the investor is bullish on the underlying.

For the patient investor who is bullish on a particular company for the long haul, writing naked puts can also be a great strategy to acquire stocks at a discount.

Put Spreads

A put spread is an options strategy in which equal number of put option contracts are bought and sold simultaneously on the same underlying security but with different strike prices and/or expiration dates. Put spreads limit the option trader’s maximum loss at the expense of capping his potential profit at the same time.

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How to Sell Put Options to Benefit in Any Market

The sale of put options allows market players to gain bullish exposure, with the added benefit of potentially owning the underlying security at a future date at a price below the current market price. A quick primer on options may be helpful in understanding how selling puts can benefit your investment strategy, so let’s examine a typical trading scenario as well as potential risks and rewards.

Call Options vs. Put Options

An equity option is a derivative instrument that acquires its value from the underlying security. Buying a call option gives the holder the right to own the security at a predetermined price, known as the option exercise price. Conversely, a put option gives the owner the right to sell the underlying security at the option exercise price. Thus, buying a call option is a bullish bet – the owner makes money when the security goes up – while a put option is a bearish bet – the owner makes money when the security goes down.

Selling a call or put option flips over this directional logic. More importantly, the holder takes on an obligation to the counter-party when selling an option because it carries a commitment to honor the position if the buyer of the option decides to exercise his or her right to own the security outright.

Here’s a summary breakdown of buying vs. selling options.

  • Buying a Call – You have the right to buy a security at a predetermined price.
  • Selling a Call – You have an obligation to deliver the security at a predetermined price to the option buyer.
  • Buying a Put – You have the right to sell a security at a predetermined price.
  • Selling a Put – You have an obligation to buy the security at a predetermined price to the option buyer.

How To Sell Put Options To Benefit In Any Market

Characteristics of Prudent Put Selling

Sell puts only if you’re comfortable owning the underlying security at the predetermined price, because you’re assuming an obligation to buy if the counter-party chooses to sell. In addition, only enter trades where the net price paid for the underlying security is attractive. This is the most important consideration in selling puts profitably in any market environment. (There are other reasons to sell puts, especially when executing more complex options strategies. Learn more in Iron Condors Fly On Fragile Wings and Advanced Option Trading: The Modified Butterfly Spread.)

Other benefits of put selling can be exploited once this important pricing rule is satisfied. The ability to generate portfolio income sits at the top of this list because the seller keeps the entire premium if the sold put expires without exercise by the counter-party. Another key benefit: the opportunity to own the underlying security at a price below the current market price.

Put Selling In Practice

Let’s look at an example of prudent put selling. Shares in Company A are dazzling investors with increasing profits from its revolutionary products. The stock is currently trading at $270 and the price-to-earnings ratio is under 20, a reasonable valuation for this company’s fast growth track. If you’re bullish about their prospects, you can buy 100 shares for $27,000 plus commissions and fees. As an alternative, you could sell one January $250 put option expiring two years from now for just $30. That means the option will expire on the third Friday of January two years from now and has an exercise price of $250. One option contract covers 100 shares, allowing you to collect $3,000 in options premium over time, less commission.

By selling this option, you’re agreeing to buy 100 shares of Company A for $250 no later than January two years from now. Clearly, since Company A shares are trading for $270 today, the put buyer isn’t going to ask you to buy the shares for $250. So, you’ll collect the premium while you wait. (Learn more about put option strategies in Bear Put Spreads: A Roaring Alternative To Short Selling.)

If the stock drops to $250 in January two years from now, you’ll be required to buy the 100 shares at that price, but you’ll keep the premium of $30 per share so your net cost will be $220 per share. If shares never fall to $250, the option will expire worthless and you’ll keep the entire $3,000 premium.

Summing up, as an alternative to buying 100 shares for $27,000, you can sell the put and lower your net cost to $220 a share (or $22,000 if the price falls to $250 per share). If the option expires worthless, you get to keep the $30 per share premium, which represents a 12 percent return on a $250 buy price.

You can see why it’s prudent to sell puts on securities you want to own. If Company A declines, you’ll be required to cough up $25,000 to buy the shares at $250 (having kept the $3,000 premium, your net cost will be $22,000). Keep in mind your broker can force you to sell other holdings to buy this position if you don’t have available cash in your account.

Deciding the best time to sell a put requires both patience and an understanding of the long term risks and rewards. Learn how to “wait for the slow pitch” from veteran options trader Luke Downey in Investopedia Academy’s Options for Beginners course.

The Bottom Line

The sale of put options can be a prudent method to generate additional portfolio income while gaining exposure to securities you would like to own but want to limit your initial capital investment.

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