How Does Selling a Put Option Work?

Options are financial contracts that derive their value from an underlying asset, such as a stock, commodity, or index. Unlike stock investing, which involves outright ownership, options trading grants specific rights or obligations without requiring immediate possession of the asset itself.

Understanding Put Options

A put option provides its buyer the right, but not the obligation, to sell an underlying asset at a predetermined price, known as the strike price, on or before a specified date, called the expiration date. This contract empowers the buyer to profit if the underlying asset’s price declines below the strike price. Each option contract typically represents 100 shares of the underlying asset.

The underlying asset is the specific security whose price movements determine the option’s value. The strike price is the fixed price at which the option holder can sell the underlying asset. The expiration date is the final day the option contract is valid.

For this right, the buyer pays a sum called the premium to the seller of the option. This premium is the cost of the option contract and is influenced by factors like the time remaining until expiration and the volatility of the underlying asset. A put option buyer anticipates that the underlying asset’s price will fall, making the right to sell at a higher, predetermined strike price valuable.

Initiating a Sold Put Position

When an investor sells, or “writes,” a put option, they take on a significant obligation rather than acquiring a right. The seller is obligated to buy the underlying asset at the strike price if the put option buyer decides to exercise their right to sell. This means the seller must be prepared to purchase shares at the agreed-upon price, regardless of the current market value.

In exchange for assuming this obligation, the seller immediately receives the premium paid by the option buyer. The act of initiating this position is often referred to as “selling to open.”

Selling put options frequently involves a strategy known as a “cash-secured put.” With a cash-secured put, the seller must have sufficient cash held in their brokerage account to cover the full cost of purchasing the shares if they are assigned.

Outcomes for a Sold Put

The fate of a sold put option depends primarily on the underlying asset’s price relative to the strike price as the expiration date approaches. There are two main scenarios that can unfold for the seller of a put option.

Option Expires Worthless

This occurs if, at the expiration date, the underlying asset’s market price is above the put option’s strike price. In this situation, the option is considered “out of the money,” and the buyer would not benefit from exercising their right to sell shares at a price lower than the market value. Consequently, the option expires unexercised, and the seller retains the entire premium received as profit.

Option is Exercised (Assigned)

This happens if, at expiration, the underlying asset’s price is below the strike price. The put option is then “in the money,” making it advantageous for the buyer to exercise their right to sell the shares at the higher strike price. As a result, the seller is obligated to purchase 100 shares of the underlying asset per contract at the strike price. The seller’s profit or loss in this case depends on the difference between the strike price (adjusted for the premium received) and the market price of the shares they now own.

To determine the point at which a sold put option begins to incur a loss, known as the break-even point. For a sold put, the break-even point is the strike price minus the premium received. If the underlying asset’s price falls below this break-even point, the seller will experience a loss on the position.