Selling puts

What Is Selling Puts?

Selling puts, also known as writing put options, is an options trading strategy where an investor opens a position by selling an options contract to another party. The seller of a put option collects a premium from the buyer in exchange for taking on the obligation to purchase the underlying asset at a predetermined strike price if the option is exercised before its expiration date. This strategy is generally employed when the seller believes the price of the underlying asset will remain above the strike price or increase by the expiration date.

History and Origin

The concept of options has roots in ancient times, with philosophical accounts suggesting their existence as far back as Ancient Greece. However, the modern, standardized options market began with the establishment of the Chicago Board Options Exchange (Cboe) in 1973. Prior to this, options were traded over-the-counter with no standardized terms, making them opaque and less accessible. The Cboe's creation marked the first time exchange-listed, standardized stock options were available to the public.¹⁶,¹⁵,,¹⁴ The Options Clearing Corporation (OCC) was also established in 1973 to ensure the fulfillment of options contracts, bringing greater credibility and security to the market.¹³,,,¹² Initially, only call options were standardized, and it wasn't until 1977 that put options were fully introduced to the exchanges.¹¹,¹⁰

Key Takeaways

• Selling puts involves receiving a premium for the obligation to buy an underlying asset at a specified strike price if the option is exercised.
• This strategy benefits when the underlying asset's price remains above the strike price or rises.
• The maximum profit for a put seller is the premium collected.
• Potential losses can be significant if the underlying asset's price falls substantially below the strike price.
• Selling puts can be used for income generation or as a way to acquire shares at a lower price.

Formula and Calculation

The primary "formula" in selling puts relates to the profit or loss calculation.

• Maximum Profit: The maximum profit for a put seller is limited to the premium received. $$\text{Max Profit} = \text{Premium Received}$$
• Breakeven Point: The breakeven point for a put seller is the strike price minus the premium received. $$\text{Breakeven Point} = \text{Strike Price} - \text{Premium Received per Share}$$
• Maximum Loss: The maximum theoretical loss for a put seller is substantial and occurs if the underlying asset's price drops to zero. $$\text{Max Loss} = (\text{Strike Price} - \text{Premium Received}) \times \text{Number of Shares per Contract}$$ For instance, if a contract covers 100 shares, the calculation would be (( \text{Strike Price} - \text{Premium} ) \times 100).

Interpreting the Selling Puts

When an investor engages in selling puts, they are essentially expressing a bullish or neutral outlook on the underlying asset. If the asset's price stays above the chosen strike price until the option's expiration date, the put option expires worthless, and the seller retains the entire premium as profit. Conversely, if the asset's price falls below the strike price, the seller might be "assigned," meaning they are obligated to buy the shares at the strike price. This scenario implies a loss, as they would be paying more than the current market value for the shares. The decision to sell a put often involves assessing the market's volatility and the perceived likelihood of the asset's price movement.

Hypothetical Example

Consider an investor, Alice, who believes that Company XYZ's stock, currently trading at $55 per share, will likely stay above $50 in the next month. To profit from this belief, Alice decides to sell a put option with a strike price of $50 and an expiration date one month away. She receives a premium of $2.00 per share (or $200 for one standard 100-share options contract).

• Scenario 1: Stock price above $50 at expiration. If Company XYZ's stock price is $52 at expiration, the put option expires worthless. Alice keeps the $200 premium, and she is not obligated to buy any shares. Her profit is $200.
• Scenario 2: Stock price below $50 at expiration. If Company XYZ's stock price drops to $48 at expiration, the put option is "in the money" and will likely be exercised by the buyer. Alice is obligated to buy 100 shares of Company XYZ at the $50 strike price, even though the market price is $48. Her cost basis for these shares would effectively be $50 - $2.00 (premium received) = $48.00 per share. She would then own 100 shares at a cost of $4,800.

Practical Applications

Selling puts can be a versatile strategy for investors seeking to generate income or acquire shares at a discount.

• Income Generation: Investors can repeatedly sell out-of-the-money puts on stocks they believe will remain stable or appreciate, collecting the premium as regular income. This approach is often part of a broader income generation strategy.
• Stock Acquisition at a Discount: For investors interested in acquiring shares of a particular company but at a lower price than current market value, selling puts can serve as a "limit order" with an added benefit. If the stock drops and the put is exercised, they buy the shares at the strike price minus the premium received, effectively getting a discount. If the stock never drops, they keep the premium and can try again. This is often referred to as a cash-secured put strategy, where the investor holds enough cash to cover the purchase of the shares.
• Portfolio Management: While primarily an income or acquisition strategy, selling puts can implicitly reflect a bullish or neutral stance on an underlying asset. Regulations around options trading are extensive, with bodies like the SEC and FINRA overseeing the markets to ensure investor protection and market integrity.⁹, The Options Clearing Corporation (OCC) serves as the central counterparty for options transactions, guaranteeing the performance of contracts and mitigating counterparty risk for market participants.⁸,⁷,

Limitations and Criticisms

Despite its potential benefits, selling puts carries significant risks and limitations:

• Unlimited Downside Risk: While the maximum profit is capped at the premium received, the potential loss can be substantial if the price of the underlying asset falls sharply. If a stock drops to zero, the put seller is obligated to buy shares at the strike price, incurring a loss equal to the strike price minus the premium collected. This contrasts sharply with buying options, where the maximum loss is limited to the premium paid.
• Assignment Risk: Put sellers face the risk of early assignment, especially if the option is deep in the money or approaching its expiration date. Early assignment can occur even if the stock price does not fall to zero, forcing the seller to purchase shares at a loss.⁶
• Margin Requirements: Selling uncovered puts (where the seller does not hold enough cash or the underlying shares to fulfill the obligation) typically requires a margin account, which involves borrowing from a broker and can amplify losses.⁵,⁴
• Opportunity Cost: If the underlying asset's price rises significantly, the put seller's profit is limited to the premium, missing out on potentially larger gains from simply owning the stock outright.
• Complexity: Derivatives like options are complex financial instruments. Regulators like FINRA emphasize the high risks associated with options trading and require brokerage firms to perform due diligence before approving customers for options trading.³,²,¹

Selling Puts vs. Buying Puts

The primary difference between selling puts and buying puts lies in the market outlook, risk-reward profile, and obligation.

Investors often confuse the two because both involve put options. However, their motivations and the market scenarios in which they profit are diametrically opposed. Selling puts is about taking on an obligation for a fee, while buying puts is about purchasing a right for a fee.

FAQs

What happens if I sell a put and the stock price drops below my strike price?

If the stock price drops below your strike price by the expiration date, the put option will likely be "in the money" and exercised by the buyer. You will then be "assigned" and obligated to purchase 100 shares of the underlying stock at the agreed-upon strike price, regardless of the current lower market price.

Is selling puts a risky strategy?

Yes, selling puts is considered a risky strategy, particularly if it's an "uncovered" put (you don't have enough cash or the underlying shares to cover the purchase). While the profit is limited to the premium received, the potential losses can be substantial if the underlying asset's price falls significantly.

Can selling puts be used for long-term investing?

Selling puts is typically a shorter-term strategy due to the finite expiration date of options contracts. However, some long-term investors use it strategically to acquire shares of a company they want to own at a desired lower price, effectively using it as a conditional limit order.

How does "cash-secured put" differ from "uncovered put"?

A cash-secured put means the seller has enough cash in their account to cover the cost of buying the 100 shares if they are assigned. This limits the risk to the amount of cash set aside. An "uncovered put" means the seller does not have the cash or the shares, and they must rely on their margin account to fulfill the obligation, which exposes them to potentially unlimited losses.