To purchase shares of new stock, seasoned investors often exercise strategies involving the sale of stock put options. Selling puts can provide money needed to purchase stocks, though it’s important to understand how these stock contracts work and how they can be used as part of your investment strategy.
What Are Put Options?
Put options are a derivative contract that grants the owner the right to sell shares of an asset at a predetermined price. Put options contain three crucial elements:
- The number of shares of a security
- The strike price (the price at which the contract allows the shares to be sold)
- The expiration date of the contract
- The premium (the price the investor pays for the options contract)
Buying puts is a common strategy when investors believe the underlying asset’s price may drop in the near future. When the asset’s market price drops below the strike price, the investor may exercise the option to sell the asset for higher than the current selling price.
For sellers, selling put options provides a strategy for earning money through the contract premium or by using the premium as a slight discount on the contract’s strike price. It can really pay off. Nasdaq reports that short sellers of Nvidia put options are making huge profits, showing the potential for this strategy.
How Do Put Options Work?
How exactly do investors benefit from selling puts? Imagine that you own 100 shares of Company XYZ. Currently, the company is trading at $150 per share — but you anticipate that the price will soon drop. You purchase a put option for Company XYZ at a strike price of $100. You pay a $5 premium to complete the contract.
If Company XYZ’s stock price drops to $90 before the expiration date of your options contract, it’s said to be “in the money” (ITM), which means that you’ll make more from the contract than if you sold the stock at the current price. You can’t sell your shares for the $100 specified in your contract.
As a result, you’ll avoid a loss of $10 per share (the difference between the contract price and the current market price). If you account for the $5 premium, your net gain is $5 per share, for a total gain of $500 for all 100 shares.
However, if Company XYZ remains above the $100 strike price, it remains “out of the money” (OTM). The contract will expire without any actual worth, and the investor will lose the premium paid for buying the contract. This is also known as “time decay” since the value of the put options contract decreases as the contract nears the expiration date.
Call Options vs. Put Options
How do put options differ from call options? Both are derivative contracts that grant the investor the right to buy or sell the underlying asset at a predetermined price. But while put options give the investor the right to sell the asset at the strike price, call options allow the investor to purchase the asset at a predetermined price.
How Selling Puts Helps You Buy Stock
Got the basics? Now, you’re ready to learn how to sell put options to gain money to buy stocks. Here’s what the process looks like.
Select a Stock and a Strike Price
Start by identifying a stock that interests you. You’ll then set a strike price, which should be lower than the current market price for that asset.
Sell the Put Option
Next, you’ll sell a put option contract for that stock at the chosen strike price. The buyer will pay you the premium for the contract and then wait for the stock price to change in value.
First Possible Outcome: The Stock Price Rises or Stays the Same
When you’re selling put options, the stock may remain OTM until the contract expires. The holder of the contractor never exercises that option, which means that you’ll have no obligation to purchase stock shares at the contracted strike price. Instead, you can keep the stock premium and use it to purchase other shares of stock.
Second Possible Outcome: The Stock Price Drops
The other possible outcome will favor the investor who purchased the contract from you. If the stock price drops, the contract is ITM, and the investor can exercise the option, which will obligate you to purchase the stock. On the one hand, you’ll be purchasing the stock shares for a higher price than the market price, but the premium you gained during the sale may offset this cost.
Selling a Put Option: Example
Admittedly, this investing strategy can be a bit complicated. It may help to look at an example of how to sell put options to buy stocks.
Imagine that you want to earn money to buy stocks. You select Company ABC, which is currently selling at $120 per share. You set a strike price of $100 and sell a put option to another investor for a $5 premium.
At this point, you’ve earned $5 from the sale of the contract. If the stock price remains above $100, the contract remains OTM. This means that you, the seller, will profit from the sale of the contract, pocketing the premium from the sale.
On the other hand, if Company ABC’s stock price drops to $75 per share, you’ll be obligated to purchase the stock at the strike price of $100 per share. You’ll still keep the $5 premium, but you’ll have to purchase the stock for a net loss of $20.
As you can see, put options are an easy way to make money from other investors — as long as the contract remains OTM. Otherwise, this strategy carries considerable risk since it’s hard to predict market volatility.
Pros and Cons of Selling Puts
Before you start selling put options on your own, you may need to think through the pros and cons of using this strategy to buy stocks.
Advantages of Selling Put Options
Positively, selling put options allows you to:
- Benefit from contract premiums without paying if the contract remains OTM
- Use the premium as a discount on stock if the contract is ITM
- Hedge bets against price swings by selling put spreads
In other words, even if the investor is obligated to purchase a stock at the contract’s stock price, the premium from the contract buyer will provide something of a “discount” on the stock itself, which can help when purchasing large quantities of stocks.
Disadvantages of Selling Put Options
Despite these advantages, selling put options can have some drawbacks, including:
- If the market drops significantly, the seller can lose a lot of money
- Contract premiums do not generate significant returns on their own
- Put options are complex for beginning traders
In the earlier examples, the market price didn’t fall far below the contract’s strike price. However, large swings can occur, which force the contract seller to purchase stock shares at a rate significantly higher than the stock’s current value. If this happens, the “discount” of the contract premium won’t be nearly enough to mitigate the loss incurred by the drop in stock price.
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