Order Entry: Credit
Ideal Environment: High IV
Profit Target: 50%
Definition: An agreement that the seller of the put option will buy a stock at a specified strike price and quantity on or before a particular date if the price of the stock gets below the strike price.
Each stock option covers 100 shares of the underlying stock.
Selling Put Options
The “writer” of the put option is obligated to buy the stock from the buyer if the option is in-the-money and the buyer so decides. The seller collects a fee (premium) when creating the put option for the risk associated with this obligation.
The risk of selling put options is having to buy stock from the buyer at the higher strike price. If the seller owns zero of the underlying security, the loss is equal to (strike price-current stock price) x (100 shares/contract). This loss is limited to the strike price x 100 net the premium collected.
Selling put options is profitable when the options sold expire worthless. The seller gets to pocket the premium. This occurs when the stock price never reaches the strike price by the expiration date. This is why people usually sell OTM put options.
As a seller of the option, the trader does not have to hold until expiration. The seller of the put is allowed to buy back the put option at a lower price for a smaller profit.
An advantage of selling options is positive theta decay (time value). As the option approaches expiration the time value portion of the option decreases. This is good for the seller of the option because if the stock does not move, they can buy the put option back for less than they sold it for and net profit the difference.
Selling OTM puts has a higher probability of success, but has a lower ROI.
In order to breakeven during the sale of an OTM put option, the price of a stock has to depreciate down to the strike price plus the premium collected.
Breakeven Stock Price = Put Strike Price - Premium Collected + Commissions
As the stock price stays at the same level or appreciates, the value of the put goes down. The time value portion of the option loses value as the option gets closer to expiration. The intrinsic value goes down as the stock price goes up.
The maximum profit is if the option expires worthless, therefore the trader gets to keep all of the premium sold. The trader can also buy back the put at a lower price for a smaller profit at any time before the expiration date as well.
Profit =Higher Premium Collected (initial sale) – Lower Premium Purchased (buying option back) - Commissions
If the stock goes down or volatility expands, the trade may still result in a small loss. The intrinsic value of the option or the time value of the option may get more expensive.
Loss = Lower Premium Collected (initial sale) - Higher Premium Purchased (buying option back) - Commissions
The max loss is limited because the downside of a stock is at $0. Selling naked short puts is risky, but the max loss is a known when the trade is first placed.
Max Loss = Limited = Premium Collected - (Strike price X 100 shares/contract) - Commissions