A put is a strategy traders or investors may use to generate income or buy stocks 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 in order to open a position. And in exchange for opening a position by selling a put, the writer receives a premium or fee, however, he is liable to the put buyer to purchase shares at the strike price if the underlying stock falls below that price, up until the options contract expires.
Profit on put writing is limited to the premium received, yet losses can be rather substantial, should the price of the underlying stock fall below the strike price. Due to the lopsided risk/reward dynamic, it may not always be immediately clear why one would take such a trade, yet there are viable reasons for doing so, under the right conditions.
- A put is an investment strategy that's employed by traders who seek to generate income or purchase shares of stock at a discounted price.
- When writing a put, the writer consents to purchasing the underlying stock at the strike price, but only under certain conditions. Mainly, the contract must be exercised.
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 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 that strike price. If writing options for income, the writer's analysis should point to the underlying stock price holding steady or rising until expiry.
For example, let's 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 a $70 strike price put 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, therefore, would face a $200 loss, 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's 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.
If the stock drops below $35, selling the option obligates the writer to buy the shares from the put buyer at $35, which is what the put seller wanted anyway. We can assume that the 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 actually $3,400. The trader is 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 remains above $35, the writer will not have the opportunity to buy the shares, but still keeps the $100 in premium received. This could potentially be done multiple times before the price of the stock finally falls enough to trigger the option to be exercised.
Closing a Put Trade
The aforementioned scenarios assume that the option is exercised or expires worthless. However, there is an entire other possibility. A put writer can close his position at any time, by buying a put. For example, 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 begin rising to $2, $3, or more dollars. The put seller is not obliged to wait until expiry. They can plainly see that they're in a losing position and may exit at any time. If option premiums are now $3, that is what they will need to buy a put option at, in order to exit trade. This will result in a loss of $2 per share, per contract.
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. Put writing is frequently used in combination with other options contracts.