Many traders are familiar with purchase options. Buy a call when you think the market will go up and buy a put when you think the market will go down.
Generally, if the market is above your call strike or below your put, you will make a profit. Several other variables play a role in determining whether or not the trade will be profitable – notably theta or the option’s time-out.
Both of the above strategies see the market directionally. In one view the market must rise, in the other it must fall. To call buyers, the call will expire worthless if the market stays where it is or increases only slightly, resulting in a loss, unless they can buy it back, which results in a smaller loss.
The game of purchase options is one with a low margin of error. But what if you could build in some margin of error so the market doesn’t have to move so much in order for you to make a profit? Selling put options is one such strategy. In this article, we’re going to examine what put-sell is and break down the key benefits and risks.
Selling put options
Selling put options is a strategy that is not as familiar as buying options. Some traders are knowledgeable about put sales but consider it extremely risky. Some even go so far as to say that there is unlimited risk in selling puts.
The particular type of “dangerous” put-sale these traders are referring to is bare put-sales. Naked Put Selling is when the put is sold directly without owning the stock (i.e. covering the option). The opening transaction in a put sale is to sell a put option instead of buying it. If you sell to open a position, you are short selling. In this case, the trader shorts the put.
For those familiar with short selling stocks, there are some similarities. A trader who shorts a stock hopes the stock price will go down. This trader has a brief bias view of the stock. Falling price is the only way he can make money trading. It’s not that easy for put sellers.
The put sale takes a neutral to bullish view of a stock. That may sound like a short circuit. If we close the option, don’t we hope the stock will fall? No. We hope the option premium will decrease. Down to zero means that the trade was successfully and completely completed. An added benefit of the fact that the premium is so low is that many brokers don’t charge an option contract fee if the premium is at or below 0.10.
What is Premium?
Every options trader deals with premium. When you buy a stock, trading becomes profitable when the stock price is above your entry price. An option is a derivative of the stock.
Instead of profiting directly from the movement of the stock price, options trading deals with movements in profits in the option price, known as the premium. Since we are shorting the put, we hope the price of the option will go down (that is, we hope the premium will go down).
Let’s look at an example of a put-sell trade. Today is 04/19/21 and Microsoft is trading at 250. A put seller wants to sell puts on May 07, 230 strike. The May 07, 230 put option is trading for 0.64 x 0.72. The trader places a limit order of 0.68 for five contracts. The order will be executed at this price.
Over the next few weeks, the price of MSFT rises to 260 and then to 240. The option premium has decreased to 0.35 x 0.40, resulting in an unrealized gain of ~ 0.30 or 5 x 0.30 x 100 = 150 USD leads. If MSFT can stay above 230 by May 7th, the trader will get the full premium, resulting in a profit of 0.68 x 5 x 100 = $ 340. Of course, the trader can buy back the option at 0.38, close the trade and make a little less profit.
connected: Analysis and Trading Options 101
Does Selling Put Options Have Unlimited Risk?
Does the put sale involve unlimited risk? No. The confusion in this statement is that put put options is equated with selling stocks.
Yes – there is unlimited risk in selling stocks short. However, selling a put option on MSFT at the 230 strike commits to buying MSFT stock at a share price of $ 230. In the worst case, MSFT drops to $ 0 before the seller executes the contract. This would result in a loss of approximately $ 23,000 (230 x 100 = $ 23,000) minus the premium you received.
That is of course still a massive loss. But the chances of MSFT dropping to $ 0 are incredibly low. Also, you would always have the option to close your position before the stock price has fallen enough to limit your losses. It is also very likely that the seller would execute the contract for profit long before the stock hit $ 0.
In any case, the maximum a seller can lose on a put sale is always a defined number. On the other hand, naked calls sell does have unlimited risk.
Selling puts far from the money (far from the current stock price) adds a lot of cushioning. This allows the stock price to move quite a bit. But it is very difficult to sell puts that are far from the money. The difficulty is finding enough rewards to make the trade worthwhile.
Put Selling is a strategy for collecting revenue. The upward trend in trading is limited to the option’s entry price. Unlike a long stock, a put seller cannot participate in an upward movement in the stock. But for those who are far from the money options and have the patience to let the rewards dwindle, this can be a worthwhile trading strategy.
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