Selling Puts, also known as writing puts can generate a profit when shares are decreasing in value. The writer hopes the market price will stay above the strike price, or “out the money”. This is a bullish move. In the money puts are worth more than out the money puts to buyers, but as a writer your “out the money puts” have a far lower chance of being exercised.
Put value increases the further into the money they are. You earn less profit for selling puts that are out the money, but won’t incur additional losses due to exercised options. Options decrease in price the further out the money they are; to offset the higher risk price won’t reach “in the money” status for the put buyer. If they do reach “in the money” status their premium value will be higher… alongside the risk of additional losses.
Puts are more valuable if the exercise price is lower. A low exercise price is more likely to be “in the money” than a high exercise price. Higher exercise prices are less valuable since they’re less likely to reach “in the money”. As compensation for this risk, premium prices are higher if the exercise price is lower. The premium paid decreases as the exercise price increases.
If you’re selling puts, you can sell puts that are already “in the money” to collect increased premiums or “out the money” puts to reduce risk of exercise by the holder. Either way, the premium is your maximum potential gain from selling puts. Options are normally only exercised if the holder will realize a profit. If they don’t, the writer collects the premium. The profit formula for selling puts is as follows:
(Where market price is the underlying price at any point for an American style option, at expiration for a European option, or average market price before expiration for an Asian style option)
The writer is making a heavy bet that the underlying asset’s price will not decrease in price before the put’s expiration date. If the asset’s price sinks, the writer may incur large losses since they must purchase the underlying asset from the put holder at a far higher price than its worth on the market. The maximum loss is limited only by the difference between the strike price and zero.
There are ways to mitigate losses if the share price drops below the exercise price. However, the strategy must be set up before the put is written. A short sale targeting the same asset as a put for the same duration protects the put writer. A short sale borrows an asset from another investor, sells it at the current market price and waits for the price to fall. The borrower reimburses the lender for any dividends received during this time period. They purchase the same asset at the lower price and return it to the investor who loaned to them. The price sold minus the price purchased is the short sale’s profit.
Writing a put on the same asset as an open short sale is a “covered” put. For example: you write a put on an underlying asset that has a market price of $40, a premium of $3, and a strike price of $35. The asset’s market price drops to $30 and the option will most likely be exercised. You will be paying $35 for an asset that is only worth $30, which results in a $5 loss. That becomes a $2 loss after including the $3 gained from the premium. If you opened at short sale at $38 and closed it at $30, you would earn $8 from the short sale. This turns your $2 loss into a profit of $6.
Beware: This strategy becomes especially dangerous if the price begins to rise. If the price rose to $50 after you opened the short sale at $40, your loss would initially be $10. The $3 gain from the premium reduces the loss to $7. A rising price first erodes profits from the premium and then creates losses. Even worse, short sale losses created by rising prices are potentially infinite. Prices can only fall to zero but they can rise to an unlimited value.
The solution is a Buy-Stop order. Buy-Stop orders instruct your broker to purchase an asset if it rises above a specific price. If you placed a buy-stop at $42 you would automatically purchase the underlying asset if it rose to that price. You would close the short and only part of your premium would be lost if the price rose to $50, instead of the $7 lost without the buy-stop order. This expands your range for profit: the price can fall below $35 and be exercised, but the short provides you with profit exceeding your losses. The price can rise above $42 and eliminate some of your premium profit, but the buy-stop saves you from losses beyond that value. Note that this is before commissions and fees, which will reduce gains and increase the losses of all the scenarios above.
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