Selling Put Options – What You Need to Know

July 13, 2017 0
Graph showing the potential profit/loss of a short put option strategy at expiration.

Ever since the rebound from the financial crisis in 2008, selling out-of-the-money put options has become a popular strategy among institutional and retail investors alike.

Essentially, there are three methods of selling puts: naked, cash-secured, and covered.

As discussed in what are stock options as well as put option explained, a put option is a financial contract that gives the buyer the right, but not the obligation, to sell the underlying security (like a stock, futures contract, or currency) at a specific price at any time until the contract expires.

Subsequently, this means the seller of a put option is obligated to buy the underly security at a specific price at any time until the contract expires. This mandatory obligation to buy the underlying asset is a key principle of selling put options vs buying put options.

 

Different Put Selling Strategies

Naked puts: Selling naked puts implies the trader uses a high degree of leverage in a margin account and does not hold enough available cash to buy the underlying asset at the short put strike price.

Cash-secured: Selling cash-secured puts means the put seller holds enough cash to purchase the corresponding amount of the underlying asset at the short put strike price.

Covered-puts: Not to be confused with cash-secured, the covered put strategy is when a trader shorts and asset and simultaneously shorts a put contract on the asset. It’s like the put version of a covered call.

 

Why Sell Put Options?

For the most part, traders like to sell put options to collect the premium. Puts that are far out-of-the-money have high probability of expiring worthless. This is because as expiration nears, OTM put options lose money due to time decay, also known as theta.

However, this is not the only reason selling put options is a popular strategy. It’s also a method of potentially going long, and getting paid to do it. Keep in mind, if you’re looking to go long an asset via a short put, you will want to make sure the puts are cash-secured, never naked, because you might have to buy the underlying at the strike price.

 

Benefits of Selling Put Options Naked

Selling naked put options certainly has its benefits, but it is also risky. Although the max loss is not unlimited, losses can mount quickly due to volatility expansion.

The benefits of selling naked puts, as opposed to cash-secured, is the ability to use more leverage and collect more premium. Naked puts don’t require the seller to keep enough cash in their account to buy 100 shares of stock (or 1 futures contract) for every put contract sold. For high-priced stocks and several indices, naked puts are more appealing because they require less capital.

 

Benefits of Selling Put Options Cash-Secured

For example, if stock XYZ is trading at $50, and a trader sells 1 $45 put, he takes on the obligation of buying 100 shares of XYZ at $45. If this is the trader’s goal, to ultimately buy XYZ stock, then selling puts is a two-for-one strategy.

If XYZ is not below $45 at expiration, the trader will keep the full premium received and can continue to sell more puts until he acquires the stock. If stock XYZ is below $45 at expiration, the trader will still keep the premium from selling the $45 put, and he will end up buying 100 shares of XYZ, which was his original goal.

 

Benefits of Selling Put Options Covered

If a trader is short 100 shares of stock XYZ at $50 a share, for example, it is a prudent strategy to reduce the cost-basis of the overall position. The most popular way of doing this is by selling covered puts.

For every 100 shares of stock, the trader can short 1 put. If the trader sells 1 $45 put, he will keep all of the premium received if XYZ is not below $45 at option expiration. If it is below $45, the short $45 put will result in the obligation to buy 100 shares of XYZ stock, which would effectively close out the short stock position. This would produce a profit of $500 ($1 per share x 100 shares) plus all of the premium received for the sale of the $45 put.

 

The Risk of Selling Puts

The risk with all options selling strategies is real. For selling put options, if the underlying asset goes to zero, the put seller will rue the day he decided to sell puts – seriously. With that said, selling OTM puts is highly effective, because often the large downward price movements necessary for the puts to expire ITM just don’t happen.

If the put is covered, there’s actually no downside risk. Selling a covered put is essentially a hedge to a short position. The risk is being short the underlying.

On the other hand, for naked and cash-secured puts, there is a huge downside risk. If the underlying asset collapses, or if volatility surges, naked and cash-secured puts are going to take on water.

 

Super Important Info On Selling Put Options

Although stocks, futures, and indices rarely go to zero, it does happen. Think, ENE, ZQK. And because it can potentially happen, puts commonly trade more expensive than calls. This is precisely what put options sellers like to take advantage of.

The seller of a put aims to capture the premium and is willing to risk a decline in the underlying asset.

The buyer of a put is willing to risk losing the premium due to upward moves in the underlying asset as well as theta decay.