Options are not just for professional or experts traders. There is a way that you, too, can make money with options. One of the most popular ways to do this is by selling put options.
While trading options can be complicated, they are beneficial because they allow traders and investors to profit from various assumptions about a stock’s future price movement when merely holding the stock would not allow them to make money.
Options are a sort of financial derivative that allows investors to purchase or sell the right to purchase or sell a stock at a certain price. This article will teach you how to sell put options and how to utilize them to earn money while safeguarding your capital or to purchase your preferred stocks at a discount.
What exactly is a Put Option?
First and foremost, it’s essential to comprehend what a put option is and how it works.
A Put option is an option to sell a security at a specified price until a certain date. It is a contract that gives the put buyer (also known as “holder”) the right, but not the obligation, to sell a security (an underlying stock or ETF) at a specified predetermined price (known as the “strike price”) within a certain time period (or “expiration date”).
In other words, the put seller is obligated to purchase something from the put buyer (should the put buyer elect to do so), at a set price, at any time during the term of the contract until it is terminated.
Put options can be used to protect against a decline in the value of the underlying security. For a put buyer, if the market price of the underlying stock moves down, he can elect to “exercise” the put option and sell the underlying stock at the strike price, even if that is higher than the price of the security on the open market.
Why Would an Investor Sell Put Options?
Investors may choose selling put options for one of two reasons: to generate income or to purchase shares at a predetermined price.
Generate Income
Selling put options, like many other options trading strategies, is one way for investors to bring in revenue.
The buyer of a put option pays you a premium when you sell the put contract. You keep the premium amount even if the buyer does not exercise the option. The greater the premium, the greater the revenue.
If the buyer does not exercise the option, your profit is the whole premium.
If the buyer executes the option, your profit or loss will be calculated as follows:
((market price – strike price) × 100) + received premium
Selling put options on a stock that you predict will remain stable or rise in value allows you to earn money with relatively low risk.
Purchase Shares at a Predetermined Price
Some investors, particularly long-term investors, conduct research on various stocks to determine their fair worth and the price they are prepared to pay for those shares. Selling put options allows these investors to purchase a stock when it falls below a certain price.
For example, if stock ABC is trading at $100 and you know you’d be prepared to purchase it at $90 or less, you may sell put options with a strike price of $90. If the stock falls below $90, the option holder will almost certainly exercise the option, and you will purchase the shares at $90 each.
The benefit of this approach is that you can gain money by selling puts before the share price hits the point at which you’re prepared to acquire shares. The risk is that if the price goes significantly below your target price, you will end up overpaying for the shares.
If, in the preceding example, the stock fell to $80 per share, you’d still pay $90 per share when the option holder exercised the option, implying you’d pay more than you could have paid on the open market. However, if you plan to keep for the long term, you can still profit in the end as the stock appreciates in value.
Advantages of Selling Put Options
Selling puts has a number of benefits over other investment strategies.
Making Money in a Sideways Market
If you purchase stock in a company, you will only make a profit if the value of the stock rises in value. When it comes to selling puts, one advantage is that it allows investors to make money even when the price of a company does not grow or decrease much.
When you sell a put option, you will receive the premium that was paid to you. As long as the strike price of the contract is below the current market price, the buyer is unlikely to exercise the option. The put seller will profit if the underlying security’s price rises, remains stable, or even falls slightly while remaining over the strike price.
This provides investors with a broader variety of possibilities for generating a return than merely purchasing stocks.
Risk Reduction
Many options methods involve theoretically infinite risk, making them unappealing to most investors. However, selling puts, like covered calls and a few other options strategies, has a low risk. If the market price of a stock or ETF falls to zero, the maximum you may lose by selling a put option is:
Worst-case scenario loss = (number of contracts x 100 x strike price) – total premium received
This is still a significant risk, but it is equivalent to the risk you take when you purchase 100 shares of the underlying securities at market value. Unlike some other derivative transactions, you can never lose more than the amount you agreed to pay for the shares.
Possibility of Price Growth
The failure scenario for selling a put option is when the option buyer exercises the option and sells you shares at a price that is higher than the market value of the shares.
However, once assigned, you can just keep the shares. If you previously planned to incorporate those shares in your portfolio as part of your investing strategy, there’s no reason you had to sell them straight away to satisfy the contract.
If you planned to hold on to the stock for the long haul, you may simply leave it in your portfolio and wait for its value to rise, eventually, selling the shares for a profit.
The Risks and Drawbacks of Selling Put Options
Put selling has a number of risks and disadvantages that should be considered before beginning.
Risk of assignment
To begin, keep in mind that by selling weekly or monthly put options, you promise to acquire the underlying equities at any time until expiration if the put buyer so desires.
The risk of selling puts is that you may end up purchasing equities for less than its true value. Indeed, you must be certain that whatever you are selling a put on is a high-quality stock or ETF that you would be glad to own today, at the agreed-upon strike price. Yes, once you possess it, you can do whatever you want with it. You can, for example, hold it or sell covered calls on it to create further revenue!
Leverage Increases the Amount of Potential Losses
Option strategies enable investors to leverage their portfolios by getting control of a large number of shares at a cheap cost.
Most options contracts contain 100 shares of the underlying stock or exchange-traded fund (ETF), but they are far less expensive than purchasing 100 shares of the underlying stock or ETF on their own. Increasing the leverage in your portfolio implies greater returns when you make a profit, but it also means greater losses when your plans do not work out as planned.
For every $1 fluctuation in the stock price, a single put option buyer can incur an extra $100 in losses if the option is exercised. It is critical for investors to be prepared for potentially significant losses when trading options.
Margin Calls
The possibility of a margin call is a significant risk associated with the use of puts because of the leverage involved.
If you sell put options, you must have enough funds to cover the cost if the option buyer exercises them. Your broker must determine if you can afford the shares you’ll need to purchase, and they must maintain track of the liabilities generated by the put options you’ve sold.
There are restrictions to how much money a broker will allow you borrow, and the amount is proportional to the value of your account.
If the market falls and you end up with a huge potential obligation as a result of the puts you sold, your broker may issue a margin call, requiring you to deposit additional money into the account to meet your liabilities.
If you are unable to satisfy the call, your broker may force you to sell additional investments, even if at a loss, in order to cover the obligation.
Profits Have a Limited Potential
The buyer of a put option pays you an option premium when you sell it. The amount you get represents the most profit you can make from the deal. In comparison to selling puts, other options techniques and investment methods have a bigger profit potential.
In most cases, the highest potential profit from selling a put is far lower than the maximum potential loss if the stock falls to a lower price after the put is sold. When selling puts, investors must maintain the balance of risk and return in mind at all times.
How to Get Started Selling Put Options
If you’ve concluded that selling put options is the right approach for you, the first step is to register an account with a brokerage firm. There are several brokers that provide options trading, so compare aspects such as the fees they charge and which one offers the best platform for you.
Next, consider the sort of security for which you wish to sell puts. In most cases, you can sell puts on stocks and ETFs. You should be reasonably confident that the security you pick will retain or increase in value.
Keep in mind that you earn when the price of the security rises or remains the same, and you lose money when the price of the security drops below the strike price of the option.
In general, selling puts on assets that are experiencing greater volatility will allow you to charge larger premiums and, hence, bigger potential earnings.
After you’ve decided on a security, you’ll need to decide on a strike price and an expiration date for your option. In general, you may charge more premiums for higher strike prices and expiration dates that are further in time.
The higher the option’s strike price, the less the stock’s value must fall in order for the buyer to benefit.
Similarly, the longer time that elapses between the option’s sale and expiration date, the more time the stock price has to fall below the strike price. Higher premiums compensate put sellers for these additional risks.
After you’ve decided on a security, strike price, and expiration date, you may issue a sell order through your brokerage account.
A Put Selling Trade Example
When you sell a put, you receive a profit (your collected premium payment) if the underlying asset’s price continues at or above the option’s strike price.
For example, if stock ABC is trading at $100, you may sell a put option contract with a strike price of $90 that expires in 60 days and get a premium payment of $200 for doing so.
If the stock price maintains over $90, you will profit $200, which is equivalent to the premium you got. Your profit is constant regardless of how high the stock price increases.
If the stock price goes below $90 and the option holder executes the option, you will lose $1 for every cent the stock falls below that level. Keep in mind that each option covers 100 shares of ABC stock, so a one-cent difference in the stock price equals a loss of one dollar.
Remember the method for determining profit or loss when a put you sell is exercised:
((market price – strike price) × 100) + received premium
If the stock price falls to $85, you must still pay $90 per share to exercise the option and can sell the shares on the open market for a loss of $100.
Your total loss is:
(($85 – $90) × 100) + $200 = -$300
If the stock falls to $80, you will lose the following:
(($80 – $90) × 100) + $200 = -$800
The larger the drop in the share price below the strike price, the higher your losses.
Conclusions
Options allow investors to leverage their portfolio and benefit in instances where merely holding stock in a company would not.
Selling put options is one of the most versatile and effective strategies for generating semi-passive income and establishing equity positions.
It’s a relatively simple and safe strategy for those investors interested acquiring their favorite stocks at a discount. Rather of buying shares at whatever the market is now offering, you may determine how much you’re ready to pay for them and then sell the put option to get paid to wait for it to fall to that level.
Frequently Asked Questions
What Kind of Money Can You Make Selling Put Options?
The amount you make is determined by the volatility of the stock market, the strike price, and the expiration date. In general, the larger the weekly and monthly income from selling put options, the more volatile the markets are. When the markets are calmer, though, you’ll need to start selling puts with a longer expiration date to achieve a higher return.
Is It Possible to Lose Money Selling Put Options?
You will never lose money selling weekly put options. To be sure, the cash you receive from selling puts is guaranteed. However, if you are exercised and you sell the shares at a loss, you may suffer a loss.
Is it Safe to Sell Puts?
Selling puts is a somewhat secure option strategy, although it is not the safest option strategy. Given the level of leverage inherent in options, the losses can be considerable, yet there is no potentially infinite loss.
Is Selling Puts a Bullish or Bearish Options Trading Strategy?
Selling puts is a bullish strategy because you benefit if the price of a stock continues high and lose money if the price decreases.
What is the Procedure for Closing a Put Option Position?
If you sold the put to start the trade, you will buy it again at the current market price to conclude it. If you purchased the put option, you will sell it to close the trade. The expiration or exercise of an option will also close the trade for both parties involved.
Which Equities are the Best for Selling Put Options?
Selling puts on high-quality stocks and index ETFs that you’d be glad to own over the long-term, can provide the most consistent returns.
What is the Risk of Selling a Put Option?
The major risk of selling put options is that the underlying stock, ETF, or futures contract will be lower at expiry than the option strike price. As a result, the trader will have to pay more for the underlying securities than it is worth.
Glossary
Strike Price
The strike price is the price indicated in the option at which you will purchase or sell the shares.
Expiration Date
An option’s expiration date is the date on which the option contract becomes void and hence worthless. The option buyer must decide whether or not to exercise the option before the expiration date.
Option Type
Call and put options are the two only forms of options. A call offers you the right to buy shares at a certain price, whereas a put gives you the right to sell shares at a predetermined price.
Premium
The premium is the amount you pay for an option contract, and it is effectively your risk premium. It’s also known as your time value.
Out-Of-The-Money
The strike price of a “Out-Of-The-Money” put option is lower than the current underlying equity price.
In-The-Money
The strike price of a “In-The-Money” put option is higher than the current underlying equity price.
At-The-Money
The strike price of a “At-The-Money” put option is about the same than the current underlying equity price.