Put writing is put selling. Put selling is put writing. Beyond the Mr. Miyagi lesson, with options trading, "writing" an option means selling it. Put writing and selling can be used in several different ways. These strategies include using them to generate income, protect investments, or take advantage of a potential decline in the price of a stock you're interested in buying.
Novice investors and traders are often mystified concerning how index put options work. While they might have a general idea of what an investor is buying when using put writing and selling, some specifics may still be unknown.
This article should give you some basic understanding of what a put is, how puts work, and what an investor is risking and should know when they buy or sell with puts.
What is a Put?
For many investors, a put is one of their favorite option strategies, and for a good reason — it can be used in several different ways. For example, investors will use puts to generate income and as a hedge for protection. Additionally, options traders who want to buy a stock at a reduced price will often buy a cash-covered put to accomplish that goal.
A put is a contract between two parties. The buyer of a put option has the right, but not the obligation, to sell the underlying stock at the strike price. However, the seller (writer) of the put is responsible for repurchasing it from the buyer at that price.
Why Would a Trader Want to Sell/Write Puts?
If you think that a stock's price will increase in the long term, but you want to lock in some income in the short term, writing cash-covered puts is an attractive strategy. The writer (or seller of puts) collects the premium upfront and can invest that money elsewhere. If the contract is exercised, the investor (or buyer of puts) must buy that stock. The only way for this trade to make sense is if the cost basis is less than what can be made from selling the contract.
What Risks are Associated with Put Selling/Put Writing?
I know what you're thinking. Isn't selling stocks short a risky proposition? Yes, it is a risky strategy. Yes, it does have risk -- just like every option strategy does -- but the rewards can be huge if you employ sound risk management with your short option strategies.
Now let's look at an example of the risks of put writing and selling works versus stock buying:
Suppose you were going to buy on Walt Disney (DIS) at $230 and initially purchased one share. Let's say that DIS drops to $0. In this case, you would have lost around $230 after subtracting the initial premium ($230 – ($230 x 1) = -$230). The break-even amount is $230 which is calculated as 230 – ($230 x 1) = -$230. This makes it necessary to collect 100% of the share price to break even or make money.
On the other hand, selling a cash-covered put option on DIS means that you're committed to buying at an agreed-upon price. If DIS dips to $0, then the seller must buy DIS stock at $230. After all, intrinsic value is the amount by which short-selling a store is "under water" (that is, selling stock and not being able to cover your short). In this case, you would owe the seller a lot of money ($230x100=$23,000).
You can see that the put option is riskier than buying smaller allotments of shares. The best way to mitigate risk is to pay attention to your open contracts because you can always exit a contract before it hits zero. Also, great news, the likelihood of DIS dropping to zero is slim to none. Also, you have the option of
How to Manage Risk Associated with Put Selling/Put Writing
Before we get started, let's assume to eliminate risk, the premium collected needs to at least cover any potential downside from the sale of the stock. Selling cash-covered puts is a highly effective options trading strategy. It generates bridging income, compresses the valuation of the portfolio and accelerates portfolio income accruals.
A cash-covered put combines an out-of-the-money put option and cash equal to the difference between the strike price and the underlying stock's market value. Investors use Cash-covered puts to protect their portfolios against a sudden drop in the market. The seller of the put option is allowed to keep both the premium from selling the option. If exercising the put option is not a viable alternative, hold on to his funds to maintain his investment portfolio strategy. If exercised, the seller will have to buy shares from the counterparty at the strike price.
Moreover, you get to keep the premium if the sold put expires worthless and the stock price moves higher than what you sold it for. Thus, this strategy has two primary risks: time decay and stock loss when the traded options expire in the money.
Put options are a powerful means to manage risk, generate income, and even profit from the price declines in your portfolio holdings. Since most investors understand calls, we'll focus here on another options strategy – selling cash-covered puts on stocks owned for portfolio management purposes.
Summary: The Risks and Rewards of Selling Puts or Writing Puts
Writing puts is not the only way to invest in the market, but it may be a smart strategy for you if you're interested in seeing more consistent income or need a hedge for protection. A "put" contract gives its owner the right but not the obligation to sell a security or other financial asset at a specific price. Cash-covered put options give investors the chance to earn a steady income from the stock market. This type of option produces different results than those received when buying a standard put option. Learning what a cash-covered put is—and how it differs from the traditional variety—will give you a better handle on how to optimize your portfolio. This article is focused on the what, why, how, and risk of put writing and selling.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
