Put writing is an essential part of options strategies. Selling a put is a strategy where an investor writes a put contract, and by selling the contract to the put buyer, the investor has sold the right to sell shares at a specific price. Thus, the put buyer now has the right to sell shares to the put seller.
Selling a put is advantageous to an investor, because he or she will receive the premium in exchange for committing to buy shares at the strike price if the contract is exercised. If the stock's price falls below the strike price, the put seller will have to purchase shares from the put buyer when the option is exercised. Therefore, a put seller usually has a neutral/positive outlook on the stock or expects a decrease in volatility that he or she can use to create a profitable position.
Why Would You Consider This Strategy?
Put writing can be a very profitable method, not only for generating income but also for entering a stock at a predetermined price. Put writing generates income because the writer of any option contract receives the premium while the buyer obtains the option rights. If timed correctly, a put-writing strategy can generate profits for the seller as long as he or she is not forced to buy shares of the underlying stock. Thus, one of the major risks the put-seller faces is the possibility of the stock price falling below the strike price, forcing the put-seller to buy shares at the strike price. Also note that the amount of money or margin required in such an event will be much larger than the option premium itself. These concepts will become clearer once we consider an example.
Instead of using the premium-collection strategy, a put writer might want to purchase shares at a predetermined price that is lower than the current market price. In this case, the put writer would sell a put at a strike price below the current market price and collect the premium. Such a trader would be eager to purchase shares at the strike price, and as an added advantage he or she makes a profit on the option premium if the price remains high. Note, however, that the downside to this strategy is that the trader is buying a stock that is falling or has fallen.
Say XYZ stock trades for $75 and its one-month $70 puts (strike price is $70) trade for $3. Each put contract is for 100 shares. A put writer would sell the $70 puts into the market and collect the $300 ($3 x 100) premium. Such a trader expects the price of XYZ to trade above $67 in the coming month, as represented below:
We see that the trader is exposed to increasing losses as the stock price falls below $67. For example, at a share price of $65, the put-seller is still obligated to buy shares of XYZ at the strike price of $70. He or she therefore would face a $200 loss, which is calculated as follows:
$6,500 (market value) - $7,000 (price paid) + $300 (premium collected).
To close out the outstanding put prior to expiry, the put-seller would purchase back the put contract in the open market. If the stock's price has remained constant or risen, the put seller will generally earn a profit on his or her position. If, however, the price of XYZ has fallen dramatically, the put-seller will either be forced to buy the put option at a much higher price or forced to purchase the shares at above-market prices. In the case of XYZ stock trading at $65, the put-seller would either be forced to pay at least $500 to repurchase the put at expiry or forced to have the shares "put" to him or her at $70, which will require $7,000 in cash or margin. Note that in either scenario, the put seller realizes a $200 loss at expiry.
The Bottom Line
Selling puts can be a rewarding strategy in a stagnant or rising stock, since an investor is able to collect put premiums without incurring significant losses. In the case of a falling stock, however, a put seller is exposed to significant risk - even though the put seller's risk is limited. In theory, any stock can fall to a value of 0. Thus, in the case of our example, the worst-case scenario would involve a loss of $6,700. As in any option trade, always make sure that you are informed about what can go wrong.
Due to the risks involved, put writing is rarely used alone. Investors typically use puts in combination with other options contracts.