Learn to Trade Options: The Perks of Put Selling

Writing puts can be an attractive way to place neutral-to-bullish bets on a stock, though there is substantial potential risk

Nov 28, 2016 at 1:18 PM
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    When most people think of options trading, buying puts and calls is generally the first thing that comes to mind. However, selling puts and calls is another way to make a profit in options trading. Under the right circumstances, put selling can be an excellent way to rake in some cash -- but it does come with its own unique set of risks.

    Put writing is for neutral-to-bullish traders, as opposed to call buying, which is for those with a more solidly bullish sentiment. When a trader purchases a call, she is indicating she expects the underlying equity to rise by a certain amount. Plus, the call buyer has the potential to see unlimited profit potential, while the risk is capped at the premium paid to enter the position, no matter how hard a stock falls.

    Put selling, however, can indicate a trader expects the underlying equity to rise, or at the very least, hold steady above a certain strike throughout the duration of the trade. When a trader writes a put, she receives the premium paid by the put buyer, which is the maximum profit the trader can expect to see -- a much more limited profit cap than call buying. (In addition, this premium can be put toward deflecting costs of other options.)

    If the stock price declines and your sold put goes in the money, the seller could be assigned -- or might end up buying to close the put at a loss, which can be steep if the shares take a serious hit. As such, the time decay that erodes an option's value as it nears expiration works in the favor of put writers, while working against call buyers. 

    Looking at a stock's implied volatility levels can help option traders determine which stocks may be ripe for a premium sale. At Schaeffer's Investment Research, a stock's Schaeffer's Volatility Index (SVI) indicates what kind of short-term volatility expectations are currently being priced in to the equity's options. If stock ABC has an SVI of 7%, which sits at the bottom of its annual range, this indicates volatility expectations are currently at their lowest levels in 12 months, making the option attractively priced to buyers, but less profitable to sell. However, if stock ABC's SVI is near the top of its annual range, this indicates option players are pricing in historically elevated volatility expectations, making XYZ options attractive to sellers, but pricier for option buyers.

    Meanwhile, an equity's Schaeffer's Volatility Scorecard (SVS) indicates how the stock has performed relative to volatility expectations over the past year. If a stock has a high SVS, the underlying equity has tended to make outsized moves on the charts over the past 12 months, relative to what the options market has priced in. For put writers, low SVS is desirable because it indicates the stock is less likely to make any large or surprising moves to place the put in the money.

    As an example, imagine a trader is fairly bullish on stock XYZ, which is currently trading for $105. The stock's elevated SVI and relatively low SVS indicate short-term premiums are relatively rich, and the stock has tended to underperform volatility expectations during the past year. Since the trader believes that XYZ will stay above the $100 level or move higher through December expiration, she decides to sell an XYZ December 100 put, which are currently bid at $0.65. This allows the trader to immediately pocket $65.

    If her hunch is correct, and XYZ finishes above the $100 level, the puts will remain out of the money and she'll be able to walk away from the trade with $65 ($0.65 x 100 shares per contract) in profit, as the put expires worthless. Of course, if, say, XYZ shares dip to the $90 level, the trader may be forced to purchase 100 shares of XYZ at $100, for a $10 per-share discount to what they're trading at on the Street.

    Clearly, it's important that a put writer be confident in an equity's near-term price action, or else she risks substantial total losses. Put sellers should also avoid writing puts for any stock they wouldn't want to eventually own, since there is always the risk of assignment at expiration. However, for put sellers who are confident that the equity will stay above the put strike, selling puts can be an efficient way to turn a profit on a stock that might have relatively inflated premiums.

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