Obligations

Before we begin the process of describing how selling Puts works, you must first be aware of some key obligations surrounding the selling of Puts:

• Put buyers have the right to sell the underlying stock.
• Put sellers are obligated to buy the underlying stock if the Put buyer so decides to exercise his or her right to sell.
• Put sellers must be financially AND psychologically prepares to buy the underlying stock.

Potential Profit and Risk of Selling Puts

• If the put buyer exercises his/her right to sell, then the put seller must buy the underlying stock and assume all of the associated risks.
• At the put’s expiration date the premium is kept as income. (The seller must make a margin deposit.)
• Unfortunately, the potential risk is frequently larger than the margin deposit.

Use the following as an example.

XYZ Stock @$71.25
Sell 1 XYZ April 70 Put @ 3.5

For a moment, suppose that you are a very conservative investor and have the cash to buy 100 shares of XYZ stock at its current price, $71.25. However, for whatever reason, you believe that XYZ will trade lower in the short term and XYZ will be able to be purchased below $70. You then develop a strategy where you sell 1 XYZ April 70 Put @3.5 and then deposit $7,000 in a money market account. There are either two outcomes to your strategy; you would be either right or wrong.

If you were correct in your supposition that XYZ will trade lower, then the put buyer exercises the put and you buy the stock for a purchase price of $66.50 (70-3.5). If your supposition was incorrect, and XYZ in fact traded higher, then the XYZ April 70 Put would expire and you would keep the $3.50 per share premium that you received.

Now, let’s look at this from a different angle. Suppose you were a very aggressive trader and have the cash to buy 100 shares of XYZ stock at its current price, $71.25. Again, for whatever reason, you believe that XYZ stock will trade between $70-$75 until its expiration. Your strategy would be to sell 1 XYZ April 70 Put @3.5 and maintain the minimum margin deposit required by your firm. Again, you are faced with only two outcomes.

If you were correct, then XYZ would stay above $70. Over time, The XYZ April 70 Put would then decrease in value. If it happens to expire worthless, then you get to keep the full premium as income. On the other hand, if your forecast was incorrect, then XYZ would fall below $70. In that case, you would then be forced to repurchase the XYZ April 70 Put at a loss or may even be forced to purchase 100 shares at $70. This loss could be considerably greater than the initial margin deposit.

As you can see, for investors who are aggressive, there is a very limited profit potential. However, if you stay more conservative, you will meet your objectives. Selling puts is a serious deal. If they are assigned, you must be able to purchase the stock at a price substantially higher than the current market price.