Why Would You Sell a Put Option? Two Key Reasons

A put option grants its holder the right, but not the obligation, to sell a specified number of shares of an underlying asset at a predetermined price, known as the strike price, on or before a particular expiration date. When an individual sells a put option, they assume an obligation to purchase 100 shares of the underlying stock at the agreed-upon strike price if the option holder chooses to exercise their right. In exchange for this obligation, the seller receives an immediate cash payment from the buyer, referred to as the premium. This upfront payment is deposited into the seller’s brokerage account. Selling a put option is a strategic decision rooted in specific financial objectives, involving a commitment to a potential future transaction balanced by the immediate receipt of income.

Selling Puts for Premium Income

One primary motivation for selling put options is to generate income from the premium collected. This premium is immediately credited to the seller’s brokerage account as direct compensation for assuming the put contract’s obligation. The ideal scenario for an income-focused put seller occurs when the underlying stock’s price remains above the chosen strike price until the option’s expiration date. In this situation, the put option expires worthless, as the buyer would not exercise their right to sell shares at a price lower than the current market value. The seller then retains the entire premium received as profit, without needing to acquire shares.

This strategy is typically employed when the seller holds a neutral to bullish outlook on the underlying stock, anticipating the price will either increase or trade sideways, staying above the strike price. The premium earned is generally treated as a short-term capital gain for tax purposes if the option expires worthless or is closed before expiration, and is typically subject to ordinary income tax rates. For most individual investors, selling cash-secured puts is the common approach.

A cash-secured put involves setting aside an amount of cash equal to the potential purchase value of the shares at the strike price. For example, selling one put option with a $50 strike price means the seller must have $5,000 (100 shares x $50) in their account to cover the potential purchase. Brokerage firms typically charge a per-contract fee for options trades, often ranging from $0.50 to $0.65 per contract, in addition to regulatory fees. These fees reduce the net premium received. While “naked puts” involve selling options without sufficient collateral and carry significantly higher risk, they are generally not recommended for individual investors.

Selling Puts for Stock Acquisition

Another significant reason for selling put options is to acquire shares of a specific stock at a desired, often lower, price. This strategy appeals to investors who wish to own a company but believe its current market price is too high, or prefer to enter at a more advantageous level. Instead of placing a traditional limit order, they sell a put option to potentially acquire the stock while also earning premium income.

This acquisition scenario unfolds if the underlying stock price falls below the chosen strike price by the option’s expiration. In this circumstance, the option holder will likely exercise their right to sell shares at the strike price, leading to “assignment” for the put seller. Assignment means the seller is obligated to purchase 100 shares of the underlying stock for each put contract sold, at the specified strike price. The Options Clearing Corporation (OCC) facilitates this process by allocating exercise notices to brokerage firms, which then assign them to their clients. The effective purchase price of the stock for the seller is the strike price minus the premium originally received.

For instance, if a put with a $45 strike price is sold for a $2 premium, and the seller is assigned, they purchase the shares at $45, but their net cost per share is effectively $43 ($45 strike – $2 premium). This is often referred to as acquiring stock at a discount, as the premium reduces the overall cost basis of the shares. The settlement period for stock trades, including those resulting from option assignment, is typically one business day (T+1).

This approach offers an advantage over simply placing a limit order, as the seller receives upfront compensation for their willingness to buy the stock. If the stock price does not drop to the strike price, the seller keeps the premium and can consider selling another put option. This strategy aligns with a long-term investment horizon, as the seller is prepared to own the stock if the option is assigned, integrating the cost of the premium into their overall investment decision.

Deciding on Strike Price and Expiration

The selection of the strike price and expiration date are two contractual terms a put seller must carefully consider, as these choices directly align with their underlying motivation for the trade. The strike price dictates the specific price at which the seller would be obligated to buy the shares if assigned. If the goal is premium income, a seller might choose an out-of-the-money strike price, meaning it is below the current market price, believing the stock is unlikely to fall that far.

Conversely, if the objective is to acquire the stock, the seller will often select a strike price that represents a desirable entry point or a price they consider fair value for the company. This could be at or slightly below the current market price. The premium received will vary based on the chosen strike; closer-to-the-money strikes generally yield higher premiums.

The expiration date establishes the timeframe during which the seller’s obligation exists. Shorter-term options, typically expiring within a few weeks or months, generally offer less premium but limit the time for the stock price to move significantly against the seller’s position. Longer-term options, extending several months or even a year out, provide a higher premium due to the increased time for potential price fluctuations, but they also expose the seller to market movements for an extended duration.

Implied volatility, which reflects the market’s expectation of future price swings, also influences the premium amount. Higher implied volatility typically results in higher premiums, making options more attractive to sellers. Understanding implied volatility helps sellers assess the attractiveness of the premium offered for a given contract.

Understanding the Outcome of the Sold Put

As a sold put option approaches its expiration, several outcomes are possible, each with distinct financial implications for the seller. The most favorable scenario for a seller focused on premium income is when the underlying stock price remains above the strike price at expiration. In this “out-of-the-money” (OTM) situation, the put option expires worthless. The seller retains the entire premium collected at the outset, and no further action is required, effectively closing the trade with a profit.

If the stock price falls below the strike price by expiration, the put option becomes “in-the-money” (ITM). In this case, the option buyer will likely exercise their right to sell the shares, leading to “assignment” for the seller. Assignment obligates the seller to purchase 100 shares of the underlying stock per contract at the strike price. For example, if a put with a $50 strike is assigned when the stock is trading at $48, the seller still buys the shares at $50, absorbing the difference.

A third scenario, “at-the-money” (ATM), occurs when the stock price is very close to the strike price at expiration. This situation can introduce uncertainty regarding assignment, as the decision to exercise might depend on minor price movements or the buyer’s specific brokerage firm policies. Generally, options that are even slightly in-the-money at expiration are automatically exercised by brokerage firms. The financial outcome for the seller directly ties back to their initial motivation. If the goal was premium income and the option expires OTM, the premium is kept as profit.

If the goal was stock acquisition and the option is assigned, the seller acquires the shares at an effective price (strike price minus premium), initiating a new long stock position. The capital gain or loss on the eventual sale of these acquired shares will depend on their holding period and the ultimate sale price.