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There are three principal reasons investors sell put options, and they all share one common denominator – an expectation that the underlying security is going to rise.
Before we examine each of these possibilities, let’s first consider exactly what a put sale is.
A Contract to Sell
When we sell a put, we’re essentially selling an opportunity to a put buyer. It’s an opportunity to:
- Sell us a specific security
- At a specific price
- Within a specific time period
For instance, we might sell him the opportunity to sell us 100 shares of Microsoft (NASDAQ: MSFT) at $40 per share until the December options expiration (one options contract equals 100 shares). And for that opportunity, he pays us cash up front. The sum we collect from him is called the “premium.”
For his part, the put buyer purchases the option because he expects the security to fall below the specified price of the options contract (the “strike price”) by expiration.
And if he’s right, and Microsoft is selling at, say, $35 per share at expiration, we’re obligated to buy those shares from him at $40, the initially agreed upon price. He thereby makes $5 per share on the venture, or $500 (he buys 100 shares at $35 and sells to us at $40).
So why do we sell puts?
Reason No. 1: To Pocket Some Cash
The first of our three reasons for selling puts is simply to collect the aforementioned premium. If we’re right, and Microsoft stock closes above the strike price at expiration, we pocket the full premium garnered at the outset of the trade.
Reason No. 2: To Buy the Stock at a Bargain Basement Price
The second reason for selling puts is related to reason No. 1, and should always be part of our trade calculus. And it is: to avail ourselves of a cheap price for Microsoft stock.
That is, if we want to own the stock, but only if we can get it for less than $40, we sell the 40 strike put and become proud owners of 100 shares of Microsoft if it closes below $40 at expiration. Our final price per share is $40 less any premium collected from the put sale.
Reason No. 3: To Close out a Short Sale
It’s a slightly more sophisticated operation, and we’ll have more to say about it at a later date, but if we’re short 100 shares of Microsoft stock and want to buy them back when the stock drops below $40, we simply sell the 40 strike put, and the trade closes automatically if Microsoft closes below that level at expiration.
When to Initiate the Sale of a Put
That being clear, when exactly do we employ the strategy?
The ideal time to sell a put is after a steep move lower on the stock, when all indications point to a firm bottom being in place and a reversal in the trend being underway.
Risk/Reward Profile
The maximum gain from the sale of a put is limited to the initial premium collected.
The maximum loss is potentially far greater. It is: the strike price times 100, less the initial premium collected. So, in our Microsoft example above, our maximum loss would be $4,000 (at the $40 strike price), less the initial premium collected.
Be careful out there, and stay tuned to Wyatt Investment Research for the Web’s clearest, no-nonsense options education.
And to learn how Wyatt Research options guru Andy Crowder sells puts in his Options Advantage service to bring in a steady income stream, click here.