A put is a method that traders or investors may employ to make revenue or to purchase equities at a lower price. When a put option is written, the writer commits to purchase the underlying stock at the strike price if the contract is executed. In this scenario, writing involves selling a put contract in order to start a position. In return for establishing a position by selling a put, the writer earns a premium or fee; nevertheless, the writer is obligated to the put buyer to purchase shares at the striking price if the underlying stock falls below that price until the options contract expires.
Profit on put writing is restricted to the premium received, but losses may be large if the underlying stock price falls below the strike price. Because of the asymmetrical risk/reward dynamic, it may not always be obvious why one would make such a transaction, but there are compelling reasons to do so given the appropriate circumstances.
- A put option is a kind of options contract that allows the holder the right, but not the responsibility, to sell the underlying asset at a predetermined price at or before the contract’s expiry date.
- Traders who want to benefit from stock falls or hedge against them may buy put options.
- Traders may also sell (write) puts to make bullish wagers or create money from investments.
- When you write a put, you agree to buy the underlying stock at the strike price if the contract expires in the money.
Put Writing for Income
Put writing creates cash since the premium is paid to the writer of any option contract while the buyer acquires the option rights. A put-writing method may provide gains for the seller if timed right, as long as they are not obliged to acquire shares of the underlying company. As a result, one of the primary dangers that the put-seller has is that the stock price will fall below the striking price, compelling the put-seller to acquire shares at that strike price. When writing income options, the writer’s analysis should indicate to the underlying stock price being stable or growing until expiration.
Assume XYZ stock is now trading at $75. Put options with a strike price of $70 are now selling at $3. Each put contract represents 100 shares. A put writer might sell a $70 striking price put and earn $300 ($3 x 100). In entering this trade, the writer believes that the price of XYZ stock will remain above $70 until expiration, or, in the worst-case scenario, above $67, which is the trade’s breakeven threshold.
As the stock price goes below $67, the trader is vulnerable to increased losses. At a share price of $65, for example, the put-seller is still required to purchase shares of XYZ at the strike price of $70. As a result, they would suffer a $200 loss, computed as follows:
- $6,500 market value less $7,000 paid plus $300 premium received equals -200
- The greater the price decline, the greater the loss to the put writer.
- If the price of XYZ at expiry is $67, the trader will have made a profit. $6,700 market value less $7,000 spent plus $300 premium received equals $0
If XYZ is higher than $70 at expiry, the trader retains the $300 and does not have to purchase the shares. The buyer of the put option intended to sell XYZ shares at $70, but since XYZ is already trading above that price, they are better off selling them at the current higher market price. As a result, the option is not exercised. This is the best circumstance for a writer of put options.
Writing Puts to Buy Stock
The next use for writing put options is to become long a stock at a reduced price.
Instead of adopting the premium-collection technique, a put writer may choose to acquire shares at a fixed price that is lower than the current market price. In this situation, the put writer might sell a put with a strike price that corresponds to the price at which they wish to acquire shares.
Assume the YYZZ stock is worth $40. An investor wants to purchase it for $35. Rather of waiting to see whether it falls below $35, the investor might write put options with a strike price of $35.
- If the price falls below $35, the writer is obligated to purchase the shares from the put buyer for $35, which is what the put seller desired anyhow. We may suppose that the seller earned a $1 premium for writing the put options, resulting in a $100 profit if just one contract was sold.
- If the price goes below $35, the writer must purchase 100 shares of stock at $35, a total cost of $3,500, but they have already received $100, so the net cost is $3,400. The trader may build a position for an average cost of $34; if they merely purchased the shares at $35, the average cost is $35. The writer lowers the cost of purchasing shares by selling the option.
- If the stock price continues over $35, the writer will be unable to purchase the shares but will retain the $100 premium earned. This might be repeated many times until the stock price falls enough to trigger the option to be exercised.
Closing a Put Trade
The alternatives shown above assume that the option is exercised or expires worthless. However, there is a whole other alternative. A put writer’s position may be closed at any moment by purchasing a put. For example, if a trader sells a put and the price of the underlying stock begins declining, the value of put will climb. If they got a $1 premium, the put premium will most certainly begin to rise to $2, $3, or more dollars as the price falls. The put seller is not required to wait until the option expires. They can clearly see that they are in a losing situation and have the option to depart at any moment. If option premiums are now $3, they will need to purchase a put option at that price to exit the deal. This will result in a $2 loss per contract share.
The Bottom Line
Selling puts may be a profitable strategy in a rising or stagnating stock since an investor can collect put premiums. In the event of a declining stock, a put seller faces enormous risk, even if the payoff is minimal. Put writing is typically combined with other types of option contracts.
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