How to Sell Puts: A Step-by-Step Process
Gain a clear understanding of selling put options. Learn the strategic approach, practical steps, and critical considerations for this financial tactic.
Options trading involves financial contracts that provide rights or obligations concerning an underlying asset. Selling put options is a strategy allowing individuals to generate income by collecting a premium. This approach involves taking on a specific obligation in exchange for immediate compensation.
Fundamentals of Put Options
A put option is a contract giving the buyer the right, but not the obligation, to sell an underlying asset at a predetermined price on or before a specific date. This asset can be a stock, Exchange Traded Fund (ETF), or index. Each option contract represents 100 shares of the underlying asset.
The predetermined price at which the asset can be sold is the strike price. Every put option has an expiration date, the final day the contract is valid. The price paid by the buyer to the seller for this right is the premium, received by the seller when the contract is initiated.
A put option’s status relative to its strike price and the underlying asset’s current market price determines its “moneyness.” An option is in-the-money (ITM) if the underlying asset’s price is below the strike price. If the underlying asset’s price is at the strike price, the option is at-the-money (ATM). If the underlying asset’s price is above the strike price, the option is out-of-the-money (OTM).
The Mechanics of Selling Put Options
When an individual sells a put option, they receive the premium upfront from the buyer. In exchange, the seller takes on a contractual obligation to purchase the underlying asset at the agreed-upon strike price if the option buyer exercises their right. This obligation remains until the option’s expiration date or until the seller closes the position.
The collected premium is the maximum profit a put seller can realize if the option expires worthless. This occurs when the underlying asset’s price remains above the strike price at expiration. In this scenario, the seller retains the entire premium without further obligation.
Conversely, if the underlying asset’s price falls below the strike price by expiration, the put option may be exercised or “assigned.” Assignment means the seller is obligated to buy 100 shares of the underlying asset per contract at the strike price, regardless of the current market price. The premium initially received helps offset the purchase price, reducing the effective cost of the shares acquired.
Practical Steps to Selling Put Options
Selling put options begins with an approved brokerage account. Most brokerage firms offer options trading, but specific approval levels are required. To sell put options, especially uncovered or “naked” puts, a higher options trading approval level (e.g., Level 3 or 4) is necessary. Obtaining this approval involves providing financial situation, investment experience, and objectives, which brokers use to assess suitability under FINRA Rule 2360.
Once approved, the next step involves researching and selecting an appropriate underlying asset and a specific put contract. This selection process includes choosing a strike price and an expiration date that align with one’s market outlook and risk tolerance.
After selecting the contract, enter the order on the brokerage platform. This involves choosing “Sell to Open” for the put option, specifying the number of contracts, and selecting an order type. A limit order is recommended to control the price received. Brokerage firms charge a per-contract fee for options trades, ranging from $0.50 to $0.75, plus regulatory fees.
Upon placing the order, it awaits execution. Once filled, the premium is credited to the account. Position management is necessary; this involves monitoring the option and potentially buying it back to close the position before expiration to realize a profit or cut a loss. Alternatively, allow the option to expire worthless, or if the price drops below the strike, prepare for assignment and purchase of the underlying shares.
Important Considerations for Put Sellers
Before selling a put option, analyzing the underlying stock is necessary. The seller must be prepared to potentially own the shares at the strike price, evaluating the company’s financial health, management, and future prospects is necessary. This analysis helps ensure acquiring the stock aligns with one’s long-term investment strategy.
Implied volatility influences options pricing. Higher implied volatility leads to higher option premiums, attractive to sellers seeking greater income. However, elevated implied volatility also suggests the market anticipates larger price swings in the underlying asset, increasing the probability of the stock price moving below the strike price and leading to assignment.
Capital requirements and margin rules are also factors. For “cash-secured puts,” the seller must set aside the full notional value of shares they would be obligated to buy if assigned, ensuring sufficient funds are available. For “naked puts” sold in a margin account, the broker requires a specific amount of capital as margin, a fraction of the total notional value, calculated as a percentage of the underlying value or strike price, plus the premium received.
Time decay, also known as theta, benefits options sellers. As an option approaches its expiration date, its extrinsic value erodes, meaning the premium decreases over time, all else being equal. This decay benefits the seller, as the option becomes less valuable, increasing the likelihood it will expire worthless and allowing the seller to keep the full premium.
Being prepared for assignment is necessary. Despite careful selection and monitoring, the underlying stock’s price can move unexpectedly below the strike price. Being financially ready and willing to purchase the shares at the strike price is necessary. This readiness involves having the necessary funds or margin available to fulfill the obligation without financial strain.