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Put writing (or selling) is a strategy that can be attractive for both options and stock traders. For options traders, it can provide consistent profits, while stock traders can use put selling as a way to get paid while waiting for a stock to pull back to an attractive purchase price. In fact, put writing puts money in your pocket right off the bat and will typically return in the neighborhood of 10 to 30 percent in under two months while the underlying stock remains flat, rises, or even falls a bit. What's more, if the stock declines by more than you expect, you can buy the stock at a significant discount to its current price.
A put option entitles the buyer to sell 100 shares of the underlying stock at the strike price on or before the expiration date. A put is in the money when the stock's price is below the strike price. A put buyer is therefore bearish on the stock, hoping that the price will decline sharply so that his option appreciates substantially. A put seller, on the other hand, is neutral to bullish on the stock and his goal is for the stock price to remain above the put's strike price. If this happens, the option will expire worthless and the put seller will retain the entire premium received from the put sale. Another benefit for the put seller is that there is no commission cost to exit a winning trade when the option expires worthless.
Put selling takes advantage of the concept of time decay-the premium an option sells for declines as the option approaches expiration. Also known as time erosion, time decay allows the options trader to profit without having to correctly predict the future direction of a stock's movement, as long as it remains above a predetermined price. Time premium will decay at a fairly predictable rate and will decay most rapidly the closer the option gets to its expiration.
Unlike stock trading, where an investor can hold on to a stagnant stock indefinitely without losing anything (except better opportunities elsewhere), the value of an option will decline if the stock fails to move. This factor benefits the put seller, while it hurts the more aggressive options buyer. Furthermore, if the price of the stock should drop below a profitable level for the options trader, put selling is a great way to acquire that stock at a lower price.
To illustrate, let's look at selling a 120-strike put on stock ABC trading at 138. With this out-of-the-money put due to expire in three weeks, we are able to collect 2.25, or $225 per contract. Let's examine how this position could have played out by looking at two possible scenarios.
The first situation is that ABC's price closed above the strike price of 120 at May expiration. In this case, the put remains out of the money and expires worthless, allowing the seller to pocket the $225 per contract sold. Note that this optimal outcome will be manifested if ABC rose, remained unchanged, or even dropped 18 points, or 13 percent, in the three weeks between opening the position and the option's expiration.
The percentage return for this trade is calculated on the initial margin. When you sell an uncovered (or "naked") put, you must make a deposit in an options account equal to a portion of the underlying shares. This deposit is the initial margin. Currently, the required minimum margin is the larger of 20 percent of the stock price plus the put premium less the amount by which the put is out of the money, or 10 percent of the stock price plus the put premium. For the ABC trade, the first method results in a margin of $1,185, as follows:
[(0.2*138) + 2.25 - 18]*100 = 1,185
However, for this example, the latter calculation applies, as the initial margin is 138 x 0.10 (10 percent of the stock price) plus 2.25 (the premium received), for a total of 16.05, or $1,605 per contract.
The initial margin is adjusted daily, decreasing as the underlying stock moves higher and increasing as the stock declines. The adjusted deposits are known as maintenance margin. The return on initial margin is calculated simply by dividing the premium ($225 per contract) by the margin ($1,605 per contract), or 14.0 percent. Keep in mind that this profit is earned over a period of only three weeks.
The second scenario comes into play if ABC were to slide below the put's strike price at 120 at or near expiration. Those who bought the sold puts could exercise their options (known as assigning their shares), obligating the put seller to purchase 100 ABC shares per contract at the strike price of 120. Since the put seller retains the premium of 2.25, the net cost to purchase the stock would be $117.75 per share (120 minus 22.25).
Thus, with a breakeven point for this trade at a stock price of 117.75, this position would not experience a loss unless the stock declined by 14.7 percent in three weeks. Note that if assignment did occur, this trade transforms into a long stock position with a purchase price of 117.75, more than 20 points below the price of ABC when the put was initially sold.
Let's say that ABC declined over the three weeks following the trade, closing at 126.25 on the day the put expired. Despite the stock's drop of 8.5 percent, the option finished substantially above the 120 strike price (out of the money), allowing the put seller to retain the premium without having to buy the shares. This example illustrates how you can attain the maximum profit with put selling even if your outlook for the underlying stock is somewhat imprecise.
The chart below illustrates how this position plays out over a wide range of stock prices at expiration. Note how profits for this position are capped at the amount of premium collected ($225), while the loss steadily increases as the stock drops below the breakeven point (line 1). However, it is important to realize that with an initial stock price of 138 (line 3), there is a wide range of probable outcomes (any stock price of at least 120 [line 2]) that will result in the maximum gain.
Before you trying your hand at put selling, here are a few helpful hints:
- If you can't afford to buy all the underlying stock that you could be obligated to buy under the put contracts that you sell, you should either reduce your put-selling exposure to an affordable level or avoid the strategy altogether. Also, since assignment will inevitably occur on some of your positions, make sure that the underlying stock is one that you would have no qualms about owning.
- Do not get enticed by the higher option premiums that more volatile stocks command, without having a sense for the stock's short-term direction. Higher premiums usually mean higher expected volatility and declines could be drastic, which could corner you into a steep losing position.
- While in-the-money puts provide larger initial premiums, we prefer to trade out-of-the-money puts because the risk of assignment is much less. Also, the capital requirement is reduced because out-of-the-money puts require smaller initial margins and their premiums deteriorate at an accelerating rate as the options approach expiration. Another advantage is that out-of-the-money put sellers can fully benefit from a flat or slightly lower move in the stock (as in the HWP example above).
- Pick a strike price for an out-of-the-money put sale that is close to a significant support level. In the event that the stock moves slightly in the money near expiration and you are assigned, you could benefit from an immediate technical rebound in the stock.
- Focus on options with one to three months until expiration. This is for two primary reasons. First, because the option-pricing model assumes that price movement is random, the premium per unit of time increases as the length of time to expiration decreases. Thus, the put seller gets more "bang for the buck" with short-term options. Second, the rate of time decay increases as the time to expiration decreases. Time decay works in favor of option sellers, and the accelerated time decay of short-term puts works best.
- Finally, your assessment of the underlying stock is the most critical factor. Selecting an optimal option strategy is no substitute for successfully gauging the future movement of the underlying stock. For put selling, focus on stocks in a strong uptrend that are relative-strength leaders, have mild to low expectations, and that have relatively little vulnerability to major "event risk" (such as a violent reaction to an earning surprise). Remember that a put seller benefits far less from a major rally in the stock relative to what can be lost in a major decline.
Because put selling is foreign to many new options traders, it is vitally important to fully understand the risks and rewards of the strategy. Of most importance is the concept that your reward is limited to the premium collected while the downside risk increases with each decline below the breakeven point before or after the stock is put to you. However, if you're prepared and willing to own the stock and can live with smaller, more consistent profits, put selling is a wonderful addition to your options arsenal.
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