Selling or writing a put is a strategy that traders or investors can use to generate income, or to buy stock at a reduced price.
When writing a put, the writer agrees to buy the underlying stock at the strike price if the contract is exercised. Writing, in this case, means selling a put contract to open a position. For opening a position by selling a put, the writer will receive a premium or fee for doing so. In exchange, they are liable to the put buyer to purchase shares at the strike price if the underlying stock falls below that price. Options expire, so the put seller is liable up until the contract expires.
Profit on put writing is limited to the premium received, yet losses can be quite large if the price of the underlying stock falls below the strike price. Because of the lopsided risk/reward dynamic, it may not be immediately apparent why someone would take such a trade, yet there are good reasons for doing so under certain conditions.
[ Put writing is a lot like writing an insurance policy for a home: you receive a premium and are only obligated to pay out if there is damage to the home. Learn how to breakdown options into easy-to-understand and relatable concepts and see real-time how options trading actually works in Invetopedia Academy's Options for Beginners course ]
Put Writing For Income
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. If writing options for income, the writer's analysis should point to the underlying stock price holding steady or rising until expiry.
Say XYZ stock trades for $75. Put options with a strike price of $70 are trading for $3. Each put contract is for 100 shares. A put writer could sell $70 strike price puts and collect the $300 ($3 x 100) premium. In taking this trade, the writer hopes that the price of XYZ stock stays above $70 until expiry, and in a worst case scenario at least stays above $67, which is the breakeven point on the trade.
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 = -200
The more the price drops, the larger the loss to the put writer.
If at expiration the price of XYZ is $67, the trader breaks even. $6,700 market value - $7,000 price paid + $300 premium collected = $0
If XYZ is above $70 at expiration the trader keeps the $300 and doesn't need to buy the shares. The buyer of the put option wanted to sell XYZ shares at $70, but since the price of XYZ is above $70 they are better off selling them at the current higher market price. Therefore, the option is not exercised. This is the ideal scenario for a put option writer.
Writing Puts to Buy Stock
The next use for writing put options to get long a stock at a discounted price.
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 could sell a put with a strike price at which they want to buy shares.
Assume YYZZ stock is trading at $40. An investor wants to buy it at $35. Instead of waiting to see if it falls to $35, the investor could write put options with a $35 price price.
If the stock drops below $35, selling the option obliges the writer to buy the shares from the put buyer at $35. This is what the put seller wanted anyway. Assume that seller received a $1 premium from writing the put options, which is $100 in income if they sold one contract.
If the price falls below $35 the writer will need to buy 100 shares of stock at $35, costing a total of $3,500, but they already received $100, so the net cost is $3,400. The trader is a able to accumulate a position at an average price of $34; if they simply bought the shares at $35 the average cost is $35. By selling the option the writer reduces the cost of buying shares.
If the price of the stock stays above $35 the writer will not have the opportunity to buy the shares, but they still keep the $100 in premium received. This could potentially be done many times before the price of the stock finally falls enough to trigger the option to be exercised.
Closing a Put Trade
The scenarios above assume that the option is exercised or expires worthless. There is a another possibility. A put writer can close their position at any time by buying a put. They sold first, so buying a put means they no longer have a position.
For example, a if a trader sold a put and the price of the underlying stock starts dropping, the value of put will rise. If they received a $1 premium, as the stock is dropping the put premium will likely start to rise to $2, $3, or more dollars. The put seller is not obliged to wait until expiry. They can see they are in a losing position and they can exit at any time. If option premiums are now $3, that is what they will need to buy a put opinion at to get out of the trade. This will result in a loss of $2 per share, per contract.
Option premiums move as the underlying stock moves, which means just like trading a stock the option traders may find advantageous time to get into and out of option trades.
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. In the case of a falling stock, a put seller is exposed to significant risk even though the profit is limited.
Selling a put can also be used to get long a stock. The benefit is that options are collected if the stock doesn't drop, and if it does the option seller can acquire the stock position for a lower cost than if they bought the stock at the strike price outright. Put writing is frequently used in combination with other options contracts.