Selling put options has a higher potential for returns than many stock investments. But, it’s important to understand the obligations you have as the put seller as well as the benefits. We’re going to explain the seller’s obligation, along with a basic example to help you understand. Plus, we’ll tell you about some benefits that can make selling put options a great strategy for your investments.
Obligations to buy the security
You can think of put options as similar to a contract between you and your insurance company. The insurance company will charge customers like you a premium for the cost of repairing damage to an insured asset during the length of the contract. If your assets don’t receive any damage during the length of the contract, the insurance company never has to pay you any money.
In the case of put option holders, if the market price goes down below the strike price, the put option holder gets to exercise the option. Then, the put option seller is obligated to buy the underlying stocks from the holder — at the strike price — to make up for the asset loss.
Put option seller obligation example
Here is a very basic example of what these obligations mean from the seller’s perspective. ABC stock is trading at $32 and the put option has a strike price of $30 with a $1 premium.
• As the seller, you receive a $100 premium ($1 x 100 shares) for selling the put the option immediately.
• You gained $100 from the premium, even if the put option holder chooses not to exercise it before it expires,
• But, if the put option holder decides to exercise the option when the market price dips below $30 — on or before the expiration — you are obligated to buy those shares at a $3,000/ The total loss depends on the market price of the shares at expiration
Risks and rewards of selling a put option
As you can see from the example above, it’s generally best to sell a put option when you think the price is going to increase. It’s also why you should only sell puts that you don’t mind owning at the strike price, because you will be obligated to buy them if the options do get exercised.
Sometimes it’s actually more beneficial to you, as the seller, when the put option holder exercises it. This is especially true if you wanted to own the stock anyway. Your obligation to buy means you get to buy the stock at the lower strike price — which is cheaper than it would be if you bought the stock instead of selling a put in the first place.
Selling puts can be a great way to generate income. Remember, you always get to keep the premium if the put option expires before being exercised.
Contact Snider Advisors for more information or help with your portfolio.