Selling Put Options

Options are financial agreements between a buyer and a seller. An option is a contract that gives the owner the right, but not the obligation, to buy or sell an underlying asset on or before a specific future date. The owner can exercise the option or simply let it expire. Options are generally tied to stocks, futures markets, or commodities.

When an investor buys an option, they enter into a contract with a seller. The contract establishes a specific price, called the strike price, at which the contract may be exercised or acted on. A contract also comes with an expiration date. When an option expires, it is defunct and no longer has any value. The investor has the option to use the contract, sell the contract, or to let it expire.

Option Types

There are two basic types of options: put options and call options. Either can be bought or sold. Put options give the holder the right to sell the asset on or before the expiration date of the contract. In general, investors buy put options when they believe the value of underlying investment will fall in value. Investors sell put options when they believe the value of the underlying investment will remain stable or increase slightly.

The value of an option depends on whether or not it is in-the-money. A seller's put option is in-the-money if the current value of the asset is above the exercise price and out-of-the-money if it is below it. If an option is not in-the-money at expiration, the option is worth nothing.

The option gives the buyer a right and creates an obligation for the seller; consequently, the buyer pays an option premium to the seller. This is the price of the option. The seller starts the contract with a net credit after collecting the premium. If the option is not exercised, the seller keeps the money. If the option is exercised, the seller keeps the premium, but must sell the underlying asset.

Selling Put Options

When an investor sells a put option, they agree to buy the underlying asset from the buyer at an agreed upon price until the contract's expiration. Per the contract, the seller of the option must buy the asset at the agreed to price, even if it is lower than the market price.

The seller of a put option is paid a premium for offering the right to the option. If the stock stays above the strike price, nothing happens, as the buyer will lose money if they exercise the option. When the option expires unused, the seller keeps the premium paid for the option. The biggest risk an investor takes when selling put options is that the underlying asset's value will fall below the exercise price. When this situation occurs, the buyer exercises the option, and the seller is forced to buy the stock at a lower price than the exercise price, consequently losing money.

Most investors utilize the basic strategy of selling put options so they can generate additional income during flat markets. Investors usually believe that the share price will remain steady or increase slightly over the option's life.

The seller's profit is limited to the premium received. The maximum loss is unlimited as the seller gradually losses more and more money as the underlying stock price falls all the way to zero.

With put options, the buyer can end the contract three different ways: let the put expire, forfeiting the premium plus any commissions paid; exercise the call at any time during the contract when the price of the underlying security is above the strike price; sell the put to another trader before the contract's expiration.

Where to get more information
Web Sites

Chicago Board Options Exchange

http://www.cboe.com

Options Clearing Corporation

http://www.optionsclearing.com

OIC - Options Industry Council

http://www.888options.com

Option Trading Tips

http://www.optiontradingtips.com

OptionXpress