A sell put option, or selling a put option that is cash-secured, is a reasonably conservative way for traders to implement options into their investment strategy. When an investor sells a put option, also known as shorting a put, they agree to purchase a stock at an agreed-upon price.
If that stock’s price falls, the investor loses money as they are required to purchase the stock at the agreed-upon or strike price while only being able to sell it for the lower price. The investor makes money if the stock’s price increases because the buyer won’t exercise the option, and the seller of the put is able to pock the fee.
Sellers have learned how to make money selling put options by writing numerous put options for stocks they believe will increase in value with the hope that the fees collected will offset any losses that occur when stock prices fall.
What Is the Sell Put Option: Selling Puts Explained
Investors sell put options on stocks they would like to own and believe are currently undervalued. They are willing to purchase the stock at the current price because they believe the price will increase in the future. They actually purchase the stock at a discount since the put’s buyer pays a sell put option fee.
A put option provides an investor with the ability to sell a stock up until a specific date, the expiration date, at a set price. If they select a strike price that is more than the current price, they are purchasing an in-the-money (ITM) put option while selecting a strike price below the current price they are purchasing an out-of-the-money (OTM) put option. When investors sell put options, they can:
- Generate double-digit returns and income even in an overvalued, flat, or bearish market. Fast business growth or a bull market isn’t needed for high market returns.
- Provide downward protection of 10% or more for your portfolio should the market crash, meaning if the market drops 35%, your equity position would only drop around 25%.
- Come into stock positions exactly where you want price point with a low-cost basis, especially if you purchase during dips to receive an even better price than what the current market is offering.
As with any tools, there’s a right place and time to sell put options. When used properly, selling a put option is an under-used and sophisticated way of entering equity positions.
When learning how to make money selling put options, investors must know and understand the basic terminology used, including:
- Strike: The price a seller is obligated to purchase the stock at if the put option buyer decides to exercise their put option and assigns stocks to the seller.
- Price: The current price that the put option is selling for and what price the put option buyer pays the put option seller.
- Change: Illustrates any recent changes in put option pricing.
- Bid: Approximation of put option premiums per share a seller will receive upfront when they sell the put option. A market maker agrees to this amount to the seller when they buy the put option from them.
- Ask: The price that a market maker charges the put option buyer to obtain the put option from them. The difference between the “ask” and “bid” is what the market maker makes in profit.
- Volume: The number of put option contracts purchased today for a strike price and expiration date.
- Open Interest: The number of existing put options for a particular strike price and expiration date or the sum of all put option volume up to the day minus any put option positions prematurely closed.
An Example on How to Make Money Selling Put Options
There are several ways investors can make money with options both through buying and purchasing put options. Below is an example of how this happens.
Deb currently holds 100 shares of ABC company stock at $100/share. She wants to sell her position at a specific price in case of the price dropping by a significant amount. Bob likes ABC stock but doesn’t believe $100 leaves enough of a safety margin and would prefer owning the stock at $90.
Bob isn’t buying at the current price but is keeping a watch on it. He isn’t concerned with predicting stock price movements; he just wants to purchase good companies at a reasonable price and has determined $90 would be an excellent price to pay using a stock valuation method. Deb and Bob make an arrangement where Bob sells Deb a put option for $6 per share for the option to purchase the stock at $90 a share with the next 12 months.
In this example, Deb pays Bob $6 per share (or $600 for 100 shares in this example), and Bob is obligated to now purchase the shares from Deb at $90 a share at any time she wants to sell the shares to him during the next 12 months.
Deb has now increased her flexibility by having the option, but no obligation to sell her shares at $90 while Bob has decreased his flexibility as he is now obligated to purchase the shares if Deb exercises her put option that he sold her.
The bonus for Bob, however, is that he wanted to purchase the shares at $90 anyway, so he’s getting paid to do what he wanted to do anyway. If it’s a cash-secured put option, he’ll have $9,000 in cash set aside over the next 12 months that can potentially be used to purchase the stock. Another alternative is for him to put the money into bonds or cash positions and waits to see if the stock price drops to his entry price of $90. He’ll perhaps make a better return as he’s getting paid to wait.
Bob’s potential cost basis in this stock is $84, or the $90 strike price minus the $6 premium paid to him by Deb. There are several scenarios that can happen over the next 12 months, including:
- ABC Stock Jumps to $120: Should the stock price jump to $120 anytime during the next 12 months, Deb won’t exercise her option to sell the stock to Bob for $100. She will let the put option expire and have basically wasted her money on it. However, she is still happy as she has made money. If she wouldn’t have purchased the put option, she would have gone from $100 to $120 for a 20% gain since she paid a $6 per share premium. She only made $14 a share or a 14% return. Bob is also reasonably happy as he made $6 per share, and the put option expired, so his money is freed up, and he is under no further obligation. When he made the deal, he basically had to front $84 a share, so his return is slightly more than 7%
- ABC Stock Remains at $100: The stock price is $100, so Deb is not going to exercise her put option, and it expires worthless. She’s not overly happy as she made a mild negative return during this period. Had she not have purchased the put option, her return would have been 0$, but since she did purchase the option, she’s down 6%. Bob is reasonably happy as his result is the same as the previous scenario. As the seller of the put option, his return for both scenarios is capped.
- ABC Stock Price Drops to $88: If the price drops to $88, Deb can force Bob to purchase the shares at $90. Deb isn’t overly happy as she lost $10 a share from the price drop and another $6 a share for the put option premium. Bob is reasonably happy as his cost basis was only $84 ($90 strike price – $6 premium), and he is able to purchase the stock he wanted at the price he wanted.
- ABC Stock Price Drops to $60: Should the stock price drop to $60, Deb forces Bob to purchase the shares at $90. While Deb still isn’t happy that she lost the $10 a share from the price drop and $6 a share premium, she is relieved she didn’t get hit with the entire $40 drop from $100 to $60. Bob isn’t exactly happy either as his cost basis in the stock was $84, and he had to purchase stocks at $60 a share. It’s still better than if he had purchased the shares at $100, so selling put options to Deb gave him a definite buffer for protecting his cash.
Selling and buying put options can be a lower-risk way for investors to generate additional income for their portfolio while gaining knowledge of the markets and valuable exposure to securities they may potentially want to own. Even better, put options can limit the amount of the initial capital investment required to get started.
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