When should you sell Put options? When should you buy them? What are the risks and rewards of stock options trading?
Buying, selling, and trading Put options in the stock market is similar to the real estate market. To understand Put options and the comparisons drawn in this article, you may want to read this one first.
To sum up the main points of the analogy, the housing market is like the stock market. Housing units are like publicly traded shares. There may be brokers, speculative buyers, and the owners of the units. A Put option contract is simply an agreement to buy shares (or a house) if the market drops to a certain value. The person selling the Put will buy shares if the market goes down to his agreed-upon price, and the buyer of the Put makes money if the market drops significantly below this amount.
Hedging the Market
Remember that Put options increase in value as the market drops. Therefore, if you own shares but want to hedge against falling prices, you can buy a Put options contract. This is exactly like buying insurance. You pay money upfront that will protect you in case of a downside crash.
Going back to our real estate analogy, this is similar to one of the condo owners (being you in this instance) making a direct deal to sell someone his home if prices fall below $250,000. He would need to pay $15,000 upfront as an ‘insurance’ premium. He now gains the peace of mind that if prices fall below $250,000, he will incur no further loss the value of his condo. He has effectively hedged himself against a massive downside risk.
Furthermore, even if prices stay above the agreed-upon purchase price (also known as a strike price), he can resell the insurance policy (Put contract) before expiration for any time value left remaining in it.
Generating Income from Selling Put Options
How can you make money from selling Put options in the stock market? First, to reduce risk we need to have enough money to actually purchase the shares if prices fall below our strike price (agreed upon purchase price). This is called a ‘cash secured’ Put options contract. If we do not have enough money to cover the transaction (and do not have a short position in the stock), this is called a ‘naked Put,’ which is dangerous. To put it succinctly, only make an agreement that you have the money to back it up with.
Next, we write and sell Put options on stocks. We set the agreed-upon purchase price, or the strike price, below the current market price. If you expect the market to be bullish, you can write ‘cash secured’ options and collect premiums without having to buy the underlying shares.
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To fully comprehend how this works, we need to use real examples. Next up, we will provide real examples of these strategies with Put options on the well-known stock Apple.
Apple Stock and Put Options Contracts
We talked earlier about receiving some money upfront, or income from writing and selling Put options. You are promising to buy shares if they fall to, or below, a certain price by a specified date. If the criteria are not met by the expiration date, you keep the full premium from selling the Put options agreement.
The main factors that determine how much premium you receive are:
How long the contract is valid forHow far below your ‘purchase price’ is from the current market priceThe expectation for volatility on stock prices
If you sell a Put contract that expires in one month, it will be worth far less than one that expires in one year; time is money. If the stock needs to fall to half of its current value before you are obligated to buy shares, you will receive far less premium than if your ‘buy in’ or strike price is equal to the current market price.
Also, you will not receive the same premium for a big blue chip stock than you will for a smaller volatile stock. With more anticipated risk comes a larger premium reward. This is also known as Implied Volatility (IV), and it refers to how much of a share price move is anticipated over the next 30 days. If IV is 20, then prices are expected to move 20% over the next 30 days.
The prices for the following Apple Put options are made on these assumptions:
Interest rate of 1%Stock price $350/shareImplied Volatility 35%365 days until expiration (Also known as LEAPS)Next, I will list the strike prices plus the premiums received for writing Put options contracts.
Strike Price =$360 Premium = $52.84Strike Price =$355 Premium = $49.64Strike Price =$350 Premium = $46.43Strike Price =$345 Premium = $43.99Strike Price =$340 Premium = $41.63Strike Price =$335 Premium = $39.29Strike Price =$330 Premium = $36.95
Hedging with Apple Put Options
It is important to understand that options are sold in lots of 100, but the prices are listed per single share. So to buy one Put options contract with a strike price of $360, I would have to pay $52.84 x 100, which is $5,284.
Imagine that I buy 100 shares of Apple stock at $350 per share for a total of $35,000. That is a lot of capital to risk, so I decided to hedge or buy insurance. The further away my strike price, the less hedging power I receive, but the cheaper my coverage becomes; this is typical for most insurances where less coverage comes with a cheaper price tag. In this instance, I choose the strike price of $330. This will cost me $36.95 x 100 or $3,695. If share prices were to drop below $330 per share, my Put options insurance would cover me. If I hold my shares for the full year, I can lose a maximum of $20 on the share price, which is $2,000, plus $3,695 for premiums paid to buy the contract. My maximum loss is $5,695 regardless of how badly the market tanks.
If Apple prices go up, I hope that the gains will outweigh the cost of insurance. The first $36.95 gain in share price will go toward paying off my Put options insurance. If market prices drop before the year is up, I can always sell my Put options to another trader. I might do so if I decide to sell my shares of Apple along with the Put options. If share prices fell to $330 in six months, the Put would not have intrinsic value yet, but it would be worth $3,140 of speculative value to another trader.
Generating Income by Selling Apple Put Options
If I expect a bull market and I have some cash to back up my strategy, I can sell cash secured Put options. First, I need to decide where my obligated buy point will be. The more unlikely the price is to be hit, the less income I will receive. In the end, I decide on a $340 strike price. This means that if share prices fall below $340 by the end of the year, I will be obligated to purchase shares at this price regardless of the market value. If shares fell to $100, I would be forced to buy them for $340 per share. If shares ended up anywhere above $340, I would simply keep the premium earned.
My broker will want me to secure $34,000 ($340 per share x 100) so that he knows I can purchase the 100 shares if required to do so. This is my total risk. I receive $41.63 x 100, or $4,163 total, as an immediate income payment for writing and selling this contract. As long as prices stay above $340, I earn over 12% annually from this strategy.
Show Me the Money
Some quick terminology you should know if selling options:
‘In-the-money’ = this simply refers to Put options contracts where the strike price is higher than the current market price ($360 Puts in the above example)’At-the-money’ = when the market price and strike price are roughly equal ($350 Puts in the above example)’Out-of-the-money’ = when the strike price is below current market value ($330 Puts in the above example)
The Put Options Wrap-up
Just remember that in general, you buy Put options as insurance to protect your investment. The other time you would buy Puts is when you expect the market to drop and you do not own the underlying asset. Put options go up as the market goes down, so this is a simple way to hedge or earn money in a down market.
You can also sell Put options to generate an income stream, but you should be prepared for the chance that, if prices drop, you will need to purchase these shares. This means that you should not simply sell Put options on any stock because the Implied Volatility is high and you will make a lot of income. Some high implied volatility stocks are extremely risky, and you may end up purchasing a boat anchor company.
For powerful hedging, speculation, and income generation, Put options contracts are useful leveraged stock derivatives.