Understanding the Consequences of Selling a Put and its Exercise
Selling put options is a common strategy among traders looking to capitalize on the volatility of a stock and its support levels. However, it is essential to understand the potential consequences when a put gets exercised, as this can significantly impact your portfolio. In this article, we delve into the details of this strategy and its potential outcomes.
What is a Put Option?
A put option is an agreement that gives the holder the right, but not the obligation, to sell a specified amount of an underlying security at a predetermined price (the strike price) within a specified time frame. As a put option seller, or a put writer, you stand ready to buy the stock at the strike price at any time until the option expires.
The Consequences of a Put Getting Exercised
If a put seller gets exercised, several consequences come into play. Here's what happens:
You become the owner of the underlying stock at the strike price, which might be beneficial if the stock price rises.
The premium you collected reduces your net purchase price, which can be advantageous in certain situations.
Should the stock get significantly lower, you might be forced to buy the stock at the strike price, leading to potential losses.
For example, if you sell a 35-striken put for $1.50 and it is exercised, you will own the stock for $35 per share on Monday after expiration. However, your net purchase price will be $33.50. This strategy is favored by Warren Buffett and is often used by companies declaring stock buybacks to purchase their own stock.
When Does it Go Wrong?
The strategy goes wrong when the stock experiences a significant drop. If the stock plummets to $28 after missing earnings, the put seller might be forced to buy the stock at the higher strike price of $35, incurring a loss. This situation carries significant risk, especially for those with a high probability of low profits.
Who Should Consider Selling Puts?
Selling puts can be a good strategy for traders with substantial capital, as it involves carrying substantial risk. Wealthy traders often use this strategy because they can afford the potential losses. However, for traders with lower capital, it is better to buy options, as the risk is typically higher for selling puts.
What Happens If a Put Is Exercised?
When a put is exercised, your broker will notify you that you are assigned. This means you become the owner of 100 shares of the underlying stock. Be aware of the ex-dividend date (XD) as early exercise of puts can occur on the day after XD.
The Basics of a Short Put Strategy
A short put strategy is typically implemented when a trader believes the stock is likely to hold above support but does not expect a significant rally. For example, with Stock XYZ trading at $27.50, the 25 level has consistently held up as support over the past couple of years. Although the stock is primarily trading sideways, the trader can sell a put at this strike to capitalize on support.
Entering the Trade
To enter the trade, the trader sells a 25-striken put, currently bid at $0.15. For every 100 shares per contract, $15 is collected. The trader's goal is for the stock to remain at or above $25 through expiration.
The maximum profit in a short put strategy is limited by the premium collected. Breakeven is calculated by subtracting the net debit from the sold put strike. In this case, breakeven is $24.85.
Potential Gains and Losses
If the stock closes at or above $24.86, the trader can leave the option to expire worthless and profit from the premium collected. However, if the stock drops below the breakeven point, significant losses can occur.
Alternately, if the stock falls below $25 at any point before expiration, the trader might be assigned, meaning they must buy 100 shares at the current market price. This results in both a loss and holding unwanted shares.
Volatility Impact
A key consideration is the impact of volatility. Falling implied volatility makes the option cheaper to buy back, which is beneficial for the put seller. However, rising implied volatility works against the put seller as it makes the option more expensive to repurchase.
Considerations for Put Sellers
Some put sellers might actually welcome assignment. By selling puts on a stock they want to own, they can collect a premium and wait for the shares to pull back to an attractive entry price. Even if the shares don't drop, the trader is compensated with the premium collected.
The main risk is if the stock experiences a sharp unexpected drop due to negative news. Assignment at a significantly lower price can cast doubt on the short put strategy's effectiveness.
In conclusion, while selling put options can be a profitable strategy for those with significant capital, it is crucial to thoroughly understand the risks involved and the potential consequences of a put getting exercised.