Beginners Guide to Selling Put Options

04/05/2011 5:00 am EST

Focus: OPTIONS

Andrea Kramer

Associate Editor, Schaeffer's Investment Research, Inc.

Learn the basics of how to identify put-selling opportunities, how to properly execute the strategy, and the key risk factors to avoid and consider.

The world of options can be intimidating to outsiders, and the jargon alone can be enough to spook even the best retail-level investors. However, here at MoneyShow.com and Schaeffer’s, we're all about breaking down the barriers, which is why we're going to show you how selling puts allows you to exploit relatively pricey options.

While a put buyer has the right to sell shares of a stock at a predetermined price (strike) before a certain time (options expiration), 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.

One popular reason to sell 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.

To pocket some premium, the trader 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 May expiration, he might consider selling the XYZ May 50 put.

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 corresponding historical volatility, the option is usually trading at a relatively higher premium than usual. In other words, selling an expensive option will generate more money at initiation, raising the put writer's maximum potential profit.

On the other hand, 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. Assuming the underlying equity can only fall as far as 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. (Don't forget to include any brokerage fees, margin requirements, or commission costs.)

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.

On the other hand, some put sellers write their options in hopes of being assigned. By selling puts on a stock you'd like to own, you can essentially "get paid to wait" to buy shares at a favorable entry price.

You might also hear a sold put referred to as a "short put." Also, in a put selling strategy, you are selling to open, which means you must buy to close (unless your option expires worthless, or unless you are assigned).

Having cleared up those lingo-related concerns, we can move on to the nitty gritty. In a purely speculative sense, you will sell (to open) a put option in order to capitalize on your expectation that the shares will remain above the strike price of that put at least through the option's expiration. In other words, you don't necessarily expect the stock to rally, but you certainly don't expect it to drop. Hence, you are neutral to bullish.

For example, let's say that stock XYZ gapped higher after reporting earnings. The shares have pulled back since, but they've consistently found support at the site of their initial bullish gap. You expect the stock will eventually resume its rally, but you're expecting a bit more consolidation above this chart support during the short term. In order to turn a profit on this expectation, you could sell a put with a strike price that most closely matches with the site of this technical support.

A short put can also be used to take advantage of stocks that are range-bound. Simply sell puts at a strike price that corresponds with the lower rail of the equity's trading range. This type of play is best implemented as the shares are rebounding off support (naturally), rather than pulling back toward it. (In trading, as in life, it's usually not wise to fight the effects of gravity.)

Now, when you decide to pull the trigger and sell a put, you will immediately collect a premium from the sale of the option. This initial premium is your maximum potential profit on the trade.

Once you've raked in your premium, there are three possible outcomes.

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In the best-case scenario, your put option will expire worthless, and you'll simply retain your initial credit and walk away a winner. In a worse-case scenario, you might have to buy to close your option, which could either eat into your profits, or potentially even result in a net loss. And in the worst-case scenario, you could be assigned, which means you will be on the hook to purchase 100 shares per contract at the strike price of the option. (Of course, this isn't always the worst thing ever—I'll explain why later.)

Since stocks can potentially fall pretty far on the charts, it's easy to see where put selling has gotten its reputation as a risky strategy. If you sell a 50-strike put on XYZ, and the shares then plummet to $5, you're going to swallow quite a loss if you're assigned. Specifically, your loss is limited only by the strike price of the option minus the premium received.

Partially because it's so risky, put selling is best limited to short-term options. On the most basic level, this gives the trade less time to move against you. Plus, the effects of time decay are more pronounced in short-term contracts, and time decay actually works in favor of option sellers. That's because time decay eats away at the price of your option, making it less expensive to repurchase if the trade backfires (all other things being equal, of course).

High implied volatility also works in favor of option sellers because it translates to a richer initial premium on the sale. Some traders try to pinpoint situations where implied volatility looks over-inflated in order to capitalize on this effect. Of course, once you're in the position, you want implied volatility to drop; otherwise, your option will be more expensive to buy back, if need be.

Now, having said all of these various things, you should be aware that many novice traders might not be authorized to sell puts. Generally, you must maintain a margin account to run these kinds of higher-risk plays, and you'll likely have to deposit a fair amount of cash to cover your risk exposure before you can sell a put. Be sure to check with your personal broker for the exact limitations and requirements on your account.

Buying Stock on a Dip

While put selling is a popular way to speculate on neutral-to-bullish price action, there's more to the story. By selling a cash-secured put, you can actually acquire the underlying stock at your desired entry price, all while turning a profit on the sale of the option. Not too shabby, right?

This option strategy simply makes it easy to follow the old investing axiom of "Buy low, sell high." If you're waiting to buy shares on a dip, you can simply sell one put option for each 100 shares you'd like to purchase. Just make sure that the strike price of your option corresponds with the magnitude of the pullback you're expecting. For example, if you're looking for the stock to pull back from $68 to $64, you could sell a 65-strike put.

Now, simultaneously, you'll set aside enough cash to purchase the appropriate number of shares at the strike price of your option. (This is where the "cash-secured" moniker comes from.) Rather than simply setting aside enough capital to satisfy your predetermined margin requirements, as with a speculative sold put, you'll be stashing away your entire possible liability on the option trade.

As you might have guessed, all you need to do after selling a cash-secured put is wait. Either wait to be assigned, or wait for the option to expire worthless—I can guarantee that one or the other will come to pass. Sometimes, witty option players will even refer to this strategy as "getting paid to wait."

As a bonus, you still get to collect a premium on the sale of your cash-secured puts. This initial premium can serve two functions. First, if the stock fails to dip as you expected, and your cash-secured put expires worthless, that initial profit is a reasonable consolation prize. Alternatively, if you do end up being assigned and buying the stock, your premium from the sale of the option can be used to lower your cost of entry on the equity investment.

As you might have noticed, cash-secured puts are substantially less scary than speculative short puts (they even have the word "secure" in their name!). For this reason, cash-secured puts are an appropriate strategy even for the novices among us.

And finally, as promised, a word about naked put writing, or, the practice of writing puts when you have neither (a) sufficient capital to buy the underlying equity at the strike price of the option, nor (b) a short position in the underlying equity.

Simply put, don't do it! In any option-writing strategy, your potential profits are very limited; and conversely, potential risk is substantial. Even if you're an expert investor, there's not much to like about those odds.

By Andrea Kramer, contributor, Schaeffer’s Trading Floor Blog

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