Selling Puts For Income

Other investors sell puts in order to collect a premium. This person is much like the insurance underwriter. He is not expecting the stock to take a plunge, but is expecting the stock to rise in price or at least retain its current value. Stock XYZ is trading a $47.50 the investor sells a $45 put contract, he collects $2 (premium) per share for doing so. As the stock rises or stays flat the principle of time decay works in the advantage of the option seller. If the stock stays above $45, the option will expire worthless and the put seller will keep the premium collected. If the stock were to fall below $45, then he would have the obligation to purchase the stock at $45 even though the stock may be trading lower.

Three scenarios when one might sell a put.

1. If XYZ is trading at $43 and you expect it to rise, you could sell 1 XYZ JUN 40 PUT for $4. As long as XYZ traded at or above the $40 strike price, the put would not be exercised and you would keep the premium.
2. XYZ drops below $40, the put would be In-the-Money and would be exercised. As the option seller you would be assigned, forcing you to purchase 100 shares of XYZ at $40, or $4,000.
3. The risk scenario is where XYZ is trading at $30 when the option expires. The option would be exercised, and you would lose $6 per share. The $30 market value of the stock, minus the $40 strike price, plus the $4 you received for selling the put.

Did you notice the numbers in each example are exactly the same, even the outcomes are similar, but the mindset can be a bit different? The danger is that the underlying stock drops dramatically and you are now obligated to purchase the stock at extremely much higher price than it is currently trading.

Put selling is designed to complement a stock-trading portfolio because it offers two methods for generating profits: collecting premium by selling an Out-of-the-Money option and/or acquiring a stock at a reduced price.

This is an advanced strategy due to the potential large cash outlay an investor might have if a put he sold was exercised. There will be a margin requirement when selling puts. It is advised that you check with your broker for the requirements needed to implement this strategy.

Put selling takes advantage of the concept of time decay because the premium an option sells for declines as the option approaches expiration. This allows the options trader to profit without having to pick a perfect entry as in the case of trading stock or call options. Time will decay most rapidly the closer the option gets to its expiration.

Put selling is similar to the activity of an insurance company. Insurance companies collect premiums for accepting the contract to cover the risks of those they insure. You act like the insurance underwriter when you sell or short puts. As an underwriter, you would insure a person’s car, home or businesses equipment in return for collecting the premium. If no claim is made against loss, then you keep the premium.

This is the crux of put writing or selling. In exchange for being paid a premium, you accept the downside risk of the underlying security. Insurance companies make billions of dollars annually because they know that you probably won’t be crashing your car and they’ve spread their obligation over many different people. You can also be handsomely paid taking on those obligations in the stock market, provided that you take the necessary steps to limit your risk.

There is an argument as to whether this is a conservative strategy or speculation. The investor who is willing to purchase the underlying security and has the means to do so is not speculating. This investor has the capital necessary to purchase the stock and even though the assignment of the stock may not be what he planned, having the stock put to him is not necessarily a bad thing either.

Put selling becomes speculative when one sells puts and does not have the financial means to purchase the stock outright. He can do this because there is only an initial margin requirement for each short put (for margin purposes, a short put is considered uncovered regardless of the amount of capitol supporting the activity). This investor has the possibility of a bigger loss than he might be prepared to accept. This could be considered as speculation.