What is Put Option Selling?
There are two ways to trade in the stock markets – cash trading and derivatives trading. Investors who have just entered the market usually look to indulge in cash trading only through equity shares and mutual funds. However, investors who have been there for a long time can indulge in complex yet profitable derivatives trading.
It allows them to make large profits by hedging against the asset classes and speculating market movements.
One such derivative product in the stock market is “Options”. Trading in options allows you to make significant gains by buying or selling a specific quantity of stocks of a certain company at a pre-determined price on or before the mutually-agreed expiry date. For Options trading, you need to buy Options contracts by paying a premium to Option writers.
Types of Options Contracts
There are two types of options contracts:
- Call Options
These contracts give the right, but not the obligation, to the buyers to purchase a certain quantity of shares at a pre-determined price (known as the strike price) on or before the contract’s expiry date. Exercising a call option is beneficial only when the current market price of a stock is more than the strike price at the time of expiry.
- Put Options
Put Options contracts are exactly the opposite of the Call Options. They give the right, but not the obligation, to the buyer to sell a certain quantity of shares at a pre-determined price on or before the contract’s expiry date. Exercising a put option is beneficial when the current market price of a stock is less than the strike price at the time of expiry.
What is Put Option Selling?
As mentioned, a put options contract gives a buyer the right, but not the obligation, to sell a specific quantity of shares of a specific company at a pre-determined price (known as the strike price) on or before the contract’s expiry date. Exercising the put option can result in profit only if the current market price of the underlying stocks is less than the strike price of the contract at the time of its expiry.
However, any trade involves two parties – a buyer and a seller, and the same is the case with Options trading. It means that when you buy a put options contract, someone has to be the seller. A Put Option seller sells you the contract and gives you the right to exercise your contract before its expiry date. And when you make profits by exercising your contract, it’s this seller who incurs losses.
Also Read: Futures Contract
How Does Put Option Selling Work?
When an investor uses the put option selling strategy, they give the right to the buyer of the Options contract to sell underlying stocks at a pre-determined price and on or before the expiry date. And if the buyer wants to exercise their contract, the put seller is required to buy the underlying stocks from them.
As a put seller, you make a profit only when the put buyer makes losses. And this can happen only when the market price of the underlying stocks starts rising instead of dipping.
When an investor buys a put option, he or she is required to pay a premium to the seller. And when the market price of the underlying stocks starts to rise, this premium dies down, and hence, the put sellers make profits when they rebuy their contracts at much lower prices.
However, one thing that you need to remember here is that you must be involved in selling put options only if you’re comfortable in owning the underlying stocks at the strike price. It’s because if the buyer chooses to exercise their Options contract, you will have to buy these stocks from them.
Why Should You Sell Put Options?
As mentioned, selling put Options allow you to make profits when the markets show bullish trends. There are two main reasons for put option selling:
- Make income from the premiums
Whenever an investor buys a Put Option, they are required to pay a premium to the Put seller or Put writer. And if the buyer of a put option doesn’t want to exercise their contract, the put seller keeps this premium as their income.
- Buy desired stocks at a price below the current market price
Selling put options works just like buying call options. It means that when you can speculate that the market price of a stock is going to rise shortly, you can sell put options. This may provide you with a chance to buy those stocks at a price below their current market price.
The Bottom Line
By selling put options, you can make decent profits and get a chance to buy your desired stocks at a price below their current market price. However, before you get involved in put options selling, it’s prudent to know the risks associated with it and the maximum quantum of loss that you can incur. Be smart and diligent while initiating any trade in the derivatives market, as it’s highly risky.
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Frequently Asked Questions
Selling a Put Option means selling someone an Options contract that gives them the right, but not the obligation, to sell the underlying stocks to you at a pre-determined price on or before the expiry date. In turn, you’re required to buy the underlying stocks from the buyer in case they decide to exercise their contract.
When you sell a Put Option, you give the right to someone to sell a certain quantity of stocks to you at a pre-determined price on or before the expiry date. However, in case the buyer doesn’t wish to sell the stocks to you, the premium paid by them becomes your profit.
The maximum loss that you can incur by selling a Put Option is equal to the strike price minus the premium received by you. This happens when the market price of the underlying stocks dips sharply, and they start trading at a price much below the strike price.