Option Basics Part 4: Selling A Put
The Last but not Least of the 4 basic option transactions
Selling a put option is the most used trade in my portfolio.
Once you get the hang of it, selling puts is very simple. However, it feels complicated due to the ‘double negative’ of selling (going short) a put (a short position). The result is being net-long the underlying stock. If having one short position in a trade is confusing, this is doubly so.
This post will make a lot more sense if you have been following along and understand how buying a put option works and how selling a call option works.
When you sell an option, you are entering into the opposite side of a contract to the option buyer. The put buyer is hoping the price of the option goes down. They pay a premium upfront and get to sell the stock at the option strike price. If the stock price is below the strike price at maturity they profit.
The put option seller is the counterparty to that trade. Therefore the put option seller is receiving a premium upfront and can be forced to buy the underlying stock at the strike price. (Note- selling an option = writing the option = short the option)
By the time you get to the end of this post, you will know how being short put options works. I also will share my all-time most used strategy.
What is Selling a Naked Put Option?
When you sell a put option, you want the price of the stock to go up. This is referred to as being ‘long’ the underlying stock.
A naked option is when the option is the only exposure you have to the underlying stock. In this introduction post, we ill view the put in isolation. In real life, you can enter into different transactions to change your net position, but for simplicity we are going to ignore it for now. Just being naked here.
Selling a naked put option has a small maximum gain and a large maximum loss. When you sell a put option you receive a premium and that is the max profit you can have on the position. However, since you are a forced buyer at the option’s strike price, you have a max loss if the stock goes to $0.
I will reuse the below graphic from part 3 since the same concept applies here.
I won’t rehash all the points from part 3 about the asymmetric downside of returns you expose yourself to by being an option seller. There is a whole section on it in the prior post. But all the points apply in case of selling puts as well. You have a capped, maximum upside that is much smaller than your maximum downside.
I would like to take a little side bar as there are 2 nuanced differences to selling a put vs selling a call. In practice these are likely not going to have a big impact, but I find them interesting to point out.
Benefit of Selling a Put vs Selling a Call - Downside & Loss Aversion:
Both selling a call and a put have similar small gain & max loss payouts. But there is 2 minor benefits that make selling a put a slight winner over selling a call in a head-to-head match-up.
Capped Downside - Selling a put has a max loss. The max loss on a put is 100% of the strike. There is no theoretical max loss when selling a call, you can lose many multiples of the option strike price.
If you have a $50 strike, the max loss when you sell a put is $5,000 minus the premium. The lowest the underlying stock can go is $0. So the max difference between the value you get (the stock at $0) vs the price you pay (the strike at $50) is capped.
However on a short call with a $50 strike, the stock could go to $1,000 a share or higher. In the case of a $1,000 share price, you lose $95,000 on the position. Technically, there is no cap on how high a stock’s price could go so your loss is infinite
Higher Premium - Generally speaking, there is a slightly higher premium on puts than calls in the market. Most investors are loss averse and many institutional investors need to protect downside risk due to the enterprise risk requirements, regulations, or prudence on leveraged strategies. This leads to a higher demand for puts in the market and a higher premium to sellers.
Loss aversion is the bias to feel more pain from a loss than pleasure from an equal gain. ie- If you win $100 you’d get a little joy, but if you lost $100 that would cause more pain than the joy from winning. Most people are loss averse, and in the market it results in more demand for puts to hedge against market declines.
Institutional investors are often ‘forced’ to buy puts. For instance, a merger arbitrage fund may lever up and capture the spread in a merger, but buy puts to prevent being blown up if the deal breaks. Or financial institutions will buy puts to help with the reserves and accounting volatility on their financial statements. Big firms have entire enterprise risk areas to manage downside exposure. etc
The actual difference of the above 2 points in practice is fairly immaterial. We are talking about less than a few nickels of higher premium. And if you sell an option on a stock it is likely a tail event if the stock then goes bankrupt or more than doubles.
Especially since you shouldn’t be selling naked option to begin with. I have all my portfolios set up to prevent margin or leverage trading to prevent me from being naked on options. However, I think this is interesting and good to know for completeness.
Selling a Put Option Example:
Keeping with the same example from Part 2: Buying a Put, below is the result of taking the other side of the trade and selling a put.
The stock is $5.50 today, and you sell a put with a $5 strike and 1 month maturity. The premium on the put is $0.30 resulting in $30 in premium collected day one. (Remember that option prices are listed as a single share but only trade in lots of 100).
Shown above, you see that the max gain of $30 happens when the stock price is $5 or higher at maturity. It doesn’t matter how high the stock goes, your upside is capped. Even at the $20 stock price (almost a 4-bagger on the stock) you only gain the premium.
Your loss is bigger the lower the ending price of the stock. The max loss here is $470. If the stock goes to $0, you still pay the $5 strike price for -$500 and you net the $30 in premium collected to get $470.
Put Option Seller’s Profit:
Expanding our example out, you get the resulting payoff graph
Starting left-to-right, you see the following:
At a $0 stock price, you have your max loss of $470. This is made up of a $500 loss on the option net the $30 premium you were paid.
You are agreeing to pay $5 per share for the underlying stock regardless of the ending price. The price of the stock is $0 and you pay $5 for what is valueless.
As the stock price increases from $0 to $4.70, the the option has a smaller loss.
At a $4.70 stock price, you breakeven. The $30 loss on the option is offset by the $30 premium you received for a $0 net profit
As the stock price increases from $4.70 to $5 your net gain increases up to $30. Then no matter how much higher the stock goes, your max gain is the $30 premium.
Why Would You Ever Sell A Put Option?!?!?
Small potential profit and large potential losses. Why would you ever sell a put option?
I only sell puts on stocks I want to own and I hold the cash to purchase the stock if it gets put to me. In the above example, I would keep the $500 cash in my account for the month till the option expires. If the stock is below $5, I pay $500 and receive 100 shares of the stock. Since this is a stock I wanted to own anyway, this is similar to using limit orders. But limit orders where you get paid money today for entering.
The above strategy is a ‘cash-secured put’ and you can read more about it here.
With my cash-secured put strategy, I choose strike prices that I would like to own the underlying stock at. So in the above example, let’s say I want to own the underlying stock at $5, then:
If the stock is below $5 I would have bought it anyway. But since I got the $30 premium, my actual cost basis on the stock is $4.70. So the ‘downside’ is that I get a stock I would buy at $5 anyway for $4.70. Not a bad downside.
If the stock is between $5-$5.30, I still profited more from selling a put as I received the $30 premium. At the end of the month, I can roll into another short $5 put or take the $530 in cash and buy 100 shares of the underlying stock.
The return on a $30 profit for holding $500 cash is 6% return for a 1 month holding period. If you are able to roll a 6% return for 12 months, that would annualize to a double (over 100% return on the full year)
If the stock ends up over $5.30, you miss out on the upside you could have had from owning the stock. This is an opportunity cost of selling a put instead of buying a stock.
The important part here, you should consider buying at least a partial position in addition to selling the put. That way you can still benefit some on a massive move up.
In the above example, the stock is currently at $5.50 and the options strike is $5, which would mean the option is out-of-the-money when written
This gives you a 10% buffer for the stock to drop before getting to your strike. ie- the stock can drop 10% before you don’t get the full $30 payout.
Stock needs to move down $0.50 from $5.50 to $5 before it is at-the-money
You get ~16% buffer before you start being at a net loss ($4.70 breakeven price)
Stock needs to move down $0.80 from $5.50 to $4.70 before you get to a net loss
Out-of-the-money options have lower premiums, but the trade-off is having some buffer in the stock movement.
This section is similar to when I sell a call on a stock I own, also known as a covered call. You are getting a little more cashflow from your portfolio.
Selling A Put Option Summary
To summarize selling a Put Option means:
You want the stock price to be above the strike at the maturity date
Your max gain is the premium you received when you sold the put
Your max loss is limited to the stock going to $0 and is equal to your strike price net premiums received
The option payoff decreases $-for-$ as the underlying stock increases from $0 up to the strike price
Selling a put option naked opens you up to huge losses
Selling a put option as part of a broader strategy can boost your portfolio cashflow and returns when done well
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