The Options 101 column introduces readers to the basics of options trading by exploring rudimentary concepts and terminology, and dissecting the risks and rewards of various strategies. Though this series is designed for option rookies, we hope seasoned options speculators can learn something, too.
In this week's edition of Options 101, we're going to analyze the ins, outs, pros and cons of selling puts.
What is a put? A put buyer has the right to sell shares of a stock at a predetermined price (strike) before a certain time (options expiration). Put purchasers are generally bearish on the underlying equity, and expect the price of the stock to fall beneath the put strike by expiration.
However, on the flip side of the aisle, writing a put obligates the seller to purchase shares of the underlying security at a predetermined price if the option is assigned. Put writers typically take a neutral to bullish stance on the stock, and anticipate the share price to remain above the put strike by options expiration.Who should tune in? There are a couple of possible objectives for writing a put. One common goal for employing this strategy is to scoop up shares of an appealing stock at a discount. If the underlying security pulls back beneath the put strike by expiration, the put seller can then acquire the shares (if assigned) at a lower price relative to when he or she initiated the sale.
Meanwhile, likely the most popular purpose behind selling puts is to pocket the initial net credit received from the sale. If the underlying stock finishes at or above the put strike by options expiration, the put will expire worthless, allowing the option player to keep the money received at initiation.
(According to Options Clearing Corporation, about half of all options are eventually bought or sold to close, while only about 17% are exercised; the other third or so typically expire worthless.)
How does it work? Assuming the trader's objective is to pocket some premium, he or she would first single out a stock with the potential to remain stagnant or move higher. The investor's anticipated trajectory for the stock should correlate with the put strike, as well as the option's expiration. In other words, if Trader Tom expects stock XYZ to remain above the $50 level through December expiration, he might consider selling the XYZ December 50 put.
What's in it for me? The maximum potential reward for selling a put is limited to the initial net credit received. Since this is the case, potential put sellers should try to single out options with elevated implied volatility levels. If an option's implied volatility reading is higher than the underlying stock's historical volatility, the option is usually trading at a relatively pricier premium than usual. In other words, selling an expensive option will generate more money at initiation, raising the put writer's maximum potential profit.
What do I have to lose? The maximum risk for writing a put is quite substantial, should the underlying stock fall beneath the put strike by expiration. In this scenario, the put buyer on the other side of the aisle could put the option to the seller, obligating him or her to purchase 100 shares of the underlying stock at the strike price. However, assuming the underlying equity falls to zero, the maximum potential loss can be calculated by subtracting the initial net credit from the put strike.
In order to avoid a loss on the play, the put seller needs the shares to remain above the breakeven level, which is also tallied by subtracting the initial premium received from the put strike.
To reduce the risk of assignment, put writers should consider selling out-of-the-money options, as these options' premiums deteriorate at a rapid rate as expiration approaches. Plus, the move required by the stock to place the put in the money is much greater with out-of-the-money puts, as opposed to options closer to the money.
(Don't forget to include any brokerage fees, margin requirements or commission costs.)
Source:
Schaeffers Investment Research
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