What Are Options | Selling Put Options
What Are Options: Selling Puts
Often there are many securities that investors would like to own for their portfolio, but they are not willing to pay the current market price. In this scenario, where an investor would like to purchase shares at a discount, the investor should consider selling or “writing” puts. Selling puts, or naked puts, is an online options strategy that can potentially allow investors to purchase stock at a discount. Writing puts is designed to allow the investor to generate additional income, in the form of a premium received, or to allow the future acquisition of stock at a discount relative to current market price. Selling puts can be used to earn additional income for a buy and hold stock portfolio. This strategy requires the investor obtain a margin account and be approved for online options trading at his/her brokerage. Also, it is highly recommended that the investor hold a substantial cash balance to avoid purchasing stock on margin. Margin is essentially borrowing money from your broker and in most cases is a poor idea.
First, let’s examine the basics.
A put option is a contract that gives the buyer the legal right to sell shares of the underlying stock at the strike price, before the expiration date. For this right, the buyer pays the seller a premium, which the seller collects and keeps. The buyer is never obligated to sell the shares and can allow the option to reach the expiration date, at which point, it expires and becomes worthless. Conversely, the seller is obligated to buy the stock at the strike price when exercised. Typically, one put option equals the right to sell 100 shares of the underlying stock at the strike price, before expiration.
Let’s run through an example for clarity…
Jill conducts a stock screen and through her research she finds an intriguing company, Waste Management, Inc. (WM). WM currently trades around $36.15/share, but Jill determines the stock is worth only $28.00/share and therefore wants to profit from what she thinks will be a decline in price. Jill could sell short 100 shares of WM, but this would require her borrowing shares from her broker for $3,615 but she doesn’t currently have enough cash. Instead, Jill can profit from a decline in share price by purchasing a put contract. She decides to purchase the 30 July 2011 put option for $0.70. This transaction cost her $70 (100X0.70).
First, when the market close arrives on the third Friday of July (option contracts expire on the third Friday of each month, well, technically on Saturday but brokers are typically closed) WM could be trading for $40/share. In this case, Jill admits she was wrong and she loses her entire $70 investment, a 100% loss. However, this is much less than if she had decided to actually execute a short sale. Secondly, Jill’s thesis could have been correct and WM closes at @27.50 on the third Friday in July. At this point her put contract is said to be “in the money” (price is less than the strike price) and the contract will be worth much more than when she originally purchased it. If Jill had owned 100 shares of WM she could then exercise her right to sell at $30, despite the fact the stock is trading at $27.50. Buying puts against stocks one currently owns to limit downside risk is called “hedging risk” or “hedging”. However, since Jill didn’t actually purchase WM shares, she simply sells her put option in the open market a few weeks before expiration at which point she receives a profit. Alternatively, Jill could purchase 100 shares of WM at $27.50 and then exercise her put option and sell them at $30, although her profit would probably decrease due to broker commission fees. Even though her put is “in the money” Jill could also take no action and let it expire.
Jack conducts a stock screen and through his research he also finds WM an intriguing company. For a number of reasons Jack believes WM has tremendous room for growth in the next 2 to 5 years but feels the current share price of $36.15 is a little more than he would like to pay. Jack feels a fair valuation for the stock is $32.50/share, but of course we would like to acquire the stock as cheap as possible. He could wait, and observe, hoping that the price retreats down to his target price of $32.50 or less. However, WM might never reach his target price, but instead head north toward $40.00 and therefore Jack has missed his opportunity and receives nothing. As an alternative, Jack decides to “sell to open” the 32 July 2011 put option for $1.30. For this sale he receives a premium of $130.
First, when July expiration rolls around WM shares could be trading north of Jack’s $32 strike price. In this case, Jack doesn’t get to purchase WM like he intended, but he did receive the $130 premium which he gets to keep and therefore still receives a profit. Second, WM could be trading lower than $32.00 at expiration and since Jack sold a put contract he is obligated to buy 100 WM shares at $32, however since he already received $130 from his put sale his actual purchase price is $30.70 (32-1.30). Jack is comfortable owning the stock at this price. Thirdly, and the worst case scenario, the SEC discovers something odd in the balance sheet and accuses WM of fraud. The stock takes a dive down to $20. Jack now has to purchase the stock at a price of $30.70, a substantial loss immediately since they are worth only $20. However, Jack could always “buy to close” his put option prior to expiration and he would cancel his obligation to purchase the stock at such an inflated price compared to market value, but he would pay more then $1.30 for the contract, and still suffer a loss.
In conclusion, selling puts is an options strategy used to generate additional income via the collection of premium. This options trading strategy can also be used to purchase a stock in the future for a price that is discounted compared to current market price. A buyer of put contracts would have reason to believe the stock price will fall, while the seller of put contracts is ready to purchase the stock below the strike price and has the buying power to do so. In general, one would want to sell a put when one has a slightly bullish view on the stock or when one would be comfortable purchasing shares at the strike price. Not all stocks allow online options trading and this example doesn’t include any broker commission fees, which can change the rate of return.
Interested in learning more? See my hub on covered calls here.
For a more advanced online options trading strategy see my hub on collars.
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