Selling, or writing, put options is typically done by professional and highly skilled traders. Strategies used for selling put options in the equities market are considered aggressive. They can be used to collect premiums or to acquire stocks at a discount to current market value.
Put options are financial contracts that give the buyer the right to sell a particular stock at the selected strike price on or before expiration. The seller of the put option is obligated to buy a particular stock at the selected strike price on or before expiration. The buyer has rights, and the maximum loss is the premium paid for the option. The seller has obligations, and the maximum loss is virtually unlimited.
At first glance, this may appear to be a bad deal for selling put options since only a small premium can be collected for assuming an unlimited risk. The put writing trade may be acceptable upon closer inspection of the actual risk and reward possibilities. Recent studies indicate that a very large percentage of options expire worthless. This is bad news for option buyers and great news for option sellers.
If the purchased option has expired worthless, the premium has been forfeited to the seller. This would suggest that option sellers are profitable more often than option buyers. Before implementing these unlimited risk trades, the investor must be informed and educated. Online resources are available to explain the risks and rewards of standardized options. Entering this market without an in-depth knowledge of selling put options could be a very risky endeavor.
A successful trade is a function of the investment objective. The objective of selling put options can be to collect the premium paid by the buyer. Another objective may be to purchase the stock at a discount to the current market value. The informed trader may select both objectives resulting in a winning trade every time. The outcome of selling a correctly placed put option trade will either be collecting a premium or purchasing the stock at a discount to the current market value. This is the best strategy for selling put options, since it can be considered a winning trade regardless of the outcome.
This type of trade is very easy to implement, but the trader must be able to evaluate the stock based on fundamental and technical analysis. The appropriate time to enter this trade is when the stock and the market in general are at or near an area of major support as determined by technical analysis. Entering this trade without the use of technical analysis is nothing more than gambling.
The foremost requirement of this strategy is the willingness and ability to purchase the stock being traded. If the investor is not interested in owning shares in the stock then this is not a good strategy. By selling a put, the trader can profit by assuming ownership of a stock that he is already interested in buying at a discount to the current market value. If this scenario does not work out then the put seller will earn the premium paid by the buyer.
The greatest risk assumed by using this strategy is the ownership of the shares. The company could declare bankruptcy resulting in a total loss for the trader. The stock may decline in value forcing the trader to hold the stock for a long period or sell the shares for a loss. Both of these scenarios could also happen if the trader bought the stock outright without capturing the discount available by selling put options.