Selling a Put Option

One more time, we’ll examine the process of selling an option, only in this instance we’ll be selling a put option instead. Just as in our previous section our ‘opening’ transaction is going to be a sell, and our ‘closing’ transaction will be a buy. However, this time we’re selling options for a different reason.

You sell a put option, when you’re expecting the price of the underlying commodity to either increase or remain unchanged.  

SELLING A PUT OPTION
As the price of the underlying commodity increases,
the value of a call option increases

Your reasoning, is that if you’re correct and the price of the commodity goes up or doesn’t move, you’ll make money by keeping the premium paid to you for the option. By selling a put option, you’re giving the buyer the right to buy a specified underlying futures contract from you at the stated strike price.

Remember, you don’t really own what you’re selling. Instead, you’re creating a situation where there will be an offsetting purchase pending, to offset the position and bring everything back to balance.

So – just as with the call option – if the buyer of the put exercises his right to buy the specified underlying futures contract at the specified strike price, you’ll have to acquire a futures position at the current market price for that particular futures contract, and then sell it back to the buyer at the strike price of the option. In effect, as an option seller, this would be your offsetting transaction if you lose with the option.

The risks associated with selling puts are similar to those associated with selling calls. Theoretically, one could argue that with a put, the lowest price the underlying commodity could reach is zero. While with a call, the highest price the underlying commodity could reach is unlimited. In practice, this makes little difference since either scenario would mean huge losses to the seller.

When selling a put, the larger the gap between the decreased
market price and the strike price, the larger your losses.

Our break-even point calculation is exactly reversed than when selling calls. Because when selling calls we made money up to the break-even point. In contrast, when selling puts, you make money down to the break-even point, since you’re working in the other direction. Therefore, you subtract the premium and add the costs of selling.
 

PUT SELLING BREAK-EVEN POINT

Breakeven price   = Strike pricePremium + Commissions & Transactions  

Your profit objective as a put option seller is to hold onto the premium you’re paid for granting the option, until the expiration of the option. And you’ll manage to do this, so long as the price of the commodity doesn’t decrease enough to make the  option profitable for the buyer. So your gain potential is limited simply to the premium amount the buyer paid you for the option.

Examples:

It’s the month of June. Wheat  -  which trades in 5,000 bushel contracts – is currently trading at $3.50 a bushel. You believe the price of wheat is going to shoot up over the next few months. So you sell a 340 September wheat put, which gives the buyer the right to buy wheat from you   at $3.40 a bushel. But since you expect the price of wheat to go up, you anticipate profiting from the premium you’re paid. To grant this right, you’re paid a premium of 22 cents a bushel, equivalent to $1,100 (.22 x 5,000 bushels, or $50 per penny). You have commission and transaction fees that come to $100 or .02 per bushel ($100/5,000 = .02). So your break-even price is $3.20 ($3.40 – .22 + .02). Which means, that once the price goes below $3.20 a bushel you start losing money.

Your brokerage account would reflect the transaction:

CREDIT ACCOUNT  PREMIUM     $1,100
LESS TRANSACTION COST           – 100

BALANCE                                        $1,000

Suppose that by expiration, sometime in August, the price of wheat rose  $3.60. This is above the strike price $3.40, thus the option would expire worthless for the buyer. Your account would reflect your net profit:

CREDIT ACCOUNT  PREMIUM     $1,100
LESS TRANSACTION COST           – 100

BALANCE                                        $1,000

Now let’s assume, instead, that the price of wheat dropped to $3.45. Though wheat didn’t go up as you had suspected it would when you sold the option, it still didn’t drop far enough for the option to become profitable to the buyer. In effect, it’s still above the strike price of $3.40. In other words, it’s still out of the money. Consequently, your net profit is $1,000.

But what happens if the price of wheat falls to $3.30? Now the buyer may exercise his option. In which case, you’d buy the option back at the exercise price of 10 cents. This means, you would end up giving back $500 of the premium (.10 x 5,000 bushels = $500), leaving your account as follows:

CREDIT ACCOUNT  PREMIUM              $1,100
LESS TRANSACTION COST                    - 100

LESS OPTION INTRINSIC VALUE          - 500  (.10 below strike price) 
NET PROFIT                                               $500

Still not too bad. However, if the price of wheat dropped to a much lower level, for instance, $2.50, then you’d suffer huge losses:

CREDIT ACCOUNT  PREMIUM              $1,100
LESS TRANSACTION COST                    - 100

LESS OPTION INTRINSIC VALUE          - 4,500  (.90 below strike price) 
NET LOSS                                             ( $3,500)

But remember, as the option writer you can buy back the option anytime before expiration and before it’s exercised, regardless of the current price of the underlying commodity.

To illustrate this with our example, let’s say the price of wheat dropped to $3.43 and you’re still a month away from expiration of the option. There’s nothing prohibiting you from closing out your position and buying back the option. The time value of the option has shrunk and it’s still not in the money, so you’ll pay a lower price for the option. The difference between the higher premium you originally received, and the lower premium you just paid to get it back, will be your profit.

In short, there are two ways to make money when selling a put option:

  1. If the price of the underlying commodity remains above the striking price of the option (or to be more precise, above yourbreak-even point).
     
  2. If the price of the underlying commodity remains stable and the option declines in time value, allowing you to buy it back at a lower premium.


Advantages And Disadvantages Of Selling Put Options     

When you sell put options, in the same matter as with selling call options, the odds are greatly on your side. The problem is that would you gain in the form of probabilities, you give up in the form of risk. As you’ve been seeing through our examples, selling options does expose you to unlimited risks.
 

ADVANTAGES:

  • Small capital commitment -The cost of selling a put option is substantially lower compared to the cost of buying a futures contract (or most any other asset.)
     
  • Higher probabilities of profit – the odds are automatically in your favor when you sell a put option. The price of the commodity can decline, remain the same, or even go up a little, and you still make money.

DISADVANTAGES:

  •  Limited profit potential – Your potential profits are limited the premium paid to you for the   option.
     
  • Unlimited risk – If the price of the commodity decreases you’re obligated to make good on the option by acquiring an opposite futures position, regardless of how low the price becomes.

 

So why do people sell put options? Again, in spite the risks, selling put options can provide you with a steady flow of income with the premiums you collect on every option. Most put options don’t become profitable for the buyer. This explains why 90% of option buyers are losers, whether they’re buying calls or puts. Either the commodity moves in the wrong direction, or it decreases in price, but not enough to reach the striking price within the life of the option, and thus expire worthless. You might also sell a put option as part of a strategy, by combining this with some other technique that may allow you to cap your risk.


 

To continue tutorial go to Options Trading Strategies