Investors who sell options contracts make their money off contract premiums that the buyer pays. As long as the buyer doesn’t exercise their contract, or if they exercise it for less than what they paid in premiums, you make money. With puts, on the other hand, you write and sell a contract in which the buyer has the right to sell you the underlying asset. You can make a steady stream of income off the premiums that these contracts generate, but be careful. You can also take substantial losses if those contracts expire in the money. Here’s how it works.
A financial advisor can answer questions about put options and help you create a financial plan for your investment needs and goals.
What Is a Put Option?
While we will focus on options involving stocks, options contracts can be written for any tradable product. An options contract is a financial asset that gives you the right to buy or sell an underlying asset. Every contract has five elements:
- Premium
- Asset
- Position (Call/Put)
- Strike Price
- Expiration Date
The premium is how much you pay to buy this contract. The asset defines what underlying asset you have the right to trade. The position determines whether this is a call contract, in which you have the right to buy the underlying asset, or a put contract, in which you have the right to sell it. The strike price is the price at which you have the right to trade this asset. The expiration date is when you can make that trade.
So, for example, take the following contract:
- $100 Premium; 100 Shares of ABC Corp. stock; Put Contract; $20/Share; August 1
It cost you $100 to buy this contract (the premium). This put option gives you the right to sell (the position) 100 shares of ABC Corp. stock (the asset) for $20 per share (the strike price) on August 1 (the expiration date). At the expiration date, you can decide whether you want to make that trade or allow the contract to expire worthless.
Put options are bets against the value of a stock. As the value of a stock goes down, the value of a put contract increases.
For example, take our contract above. You have the right to sell ABC Corp. stock for $20 on August 1. Say this stock is trading for $15 per share on the expiration date. You can go out and buy 100 shares of stock for $1,500, then sell those shares for $2,000. You end up profiting $500 on this trade, or $400 in total after accounting for the contract’s premium.
On the other hand, say that ABC Corp. stock is trading for $30 per share on August 1. You would lose $1,000 by selling this stock. So instead you can let the contract expire worthless.
Writing Put Options
Every options contract has two parties: the person who buys, or “holds,” the contract and the person who sells, or “writes,” the contract. The person who writes an options contract is on the other end of any trade in this deal. This means that with a put contract:
- The holder has the right to sell the underlying asset to the writer.
- The writer has the obligation to buy the underlying asset from the writer.
When you write a put contract, you’re betting that the price of the stock will go up. If the stock’s price increases, the contract will expire worthless. If the stock’s price falls, you may have to buy those shares from the holder.
That obligation is the big difference between holding an options contract and writing one.
When you write options, you must execute the trade if the holder chooses to exercise their contract. This creates different risk profile. The person who holds a contract can walk away if they would lose money. The person who writes the contract can’t.
That said, the risk of a put contract is limited. While you lose money if the stock’s price falls, it can’t fall below $0. This caps and defines your exposure.
Take our example above. Say the price of ABC Corp. falls to $0 and the holder executes their contract. You have to buy 100 shares of worthless stock for $2,000 (the strike price of $20 per share). That’s the maximum amount of risk you assume under this contract.
This is as opposed to writing call contracts. Under a call contract, the writer loses money if the stock price goes up. Since there is no theoretical limit to how high a stock’s price can go, there’s no upper limit to your exposure under this contract.
Writing Puts for Income
For professional investors, writing put contracts is a common form of income investing.
When you write an options contract, you receive the contract premium up front. If you sell a put contract with a $100 premium, you receive that $100 as immediate return. Writing put contracts can generate a steady stream of income for your portfolio. The critical issue is managing your risk.
Stock options are sold in contracts of 100 shares. For every put contract you write, you’re agreeing to buy 100 shares of stock from the holder.
This can help you price your premiums. For every $1 that the stock’s price declines below the contract’s strike price, you lose $100. For example, take our contract for ABC Corp. with a $20 strike price above. You have the obligation to buy this stock for $2,000 if the holder chooses to exercise their option. If the stock is worth $19 per share you pay $2,000 to buy $1,900 worth of stock, a $100 loss. If it worth $18 per share, you pay $2,000 to buy $1,800 worth of stock, a $200 loss. And so on.
The point at which your premiums balance your losses is called the breakeven. In our example, $19 per share is your breakeven. If the stock is worth more than that, your premiums exceed your potential losses. If the stock is worth less than that, your potential losses exceed your premiums.
This is the judgment call. For every dollar you expect the stock to move, you want to add an additional $100 to your premiums. The higher your premiums the more money you make by writing these contracts and the more insulated you are from loss, but also the fewer investors will buy your contracts.
Writing Puts for Long-Term Investing
While some options are cash settled, meaning that you only exchange the value of the contract, with most put contracts you agree to actually buy and take possession of the underlying stock.
Many investors write put contracts for stocks that they would like to own. In this case, you can write your contract with an eye toward long-term investing. Set a strike price that you think is fair for the stock’s overall value. If the stock’s price falls below this value, the contract holder will exercise their option. You will end up owning those shares at a potential short-term loss, but hopefully a long-term gain, and you’ll get paid a premium for investing in a stock that you planned on buying anyway.
That said, this approach is difficult for active income investing. It’s unlikely that you will have a high volume of stocks that you want to trade as long-term investments, which will limit the number of contracts you can sell.
Selling Puts Is Extremely Risky
Historically, options have been an asset limited to professional and experienced investors. This is because they are a potentially high-risk asset class, and that’s particularly true for writing an options contract.
When it comes to selling puts, you can lose a lot of money very easily. Those losses can quickly dwarf any gains you made from contract premiums.
This risk profile is also asymmetric for most retail investors because it comes in the form of active losses. Most investors understand the passive loss risk profile of stocks and other investments. With those assets, you can’t lose more than the money you put in. Writing an options contract entails active losses, meaning that if the value of your investment declines you will owe additional money to cover your losses.
Your scope of risk is unpredictable and potentially significant. It is very important not to underestimate that.
Bottom Line
When you sell, or “write,” an options contract you make money from the premiums that the buyer pays you. But be careful. Writing a put contract comes with potentially significant risks.
Tips for Investors
- If you’re interested in selling puts for income, a financial advisor can help you create a financial plan for your investments. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you need help balancing your investment portfolio, SmartAsset’s free asset allocation tool can show you different portfolio breakdowns based on your risk profile.
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