Selling a Put

When you buy a put you expect the stock to drop in price and when you sell a put you expect the stock to increase in price.  You will however, make a profit if the stock increases, does not change, or even drops a little.  In fact, if you can pick a stock that does not change at all, you can double your money in a year.

When someone buys a put he or she has the right to sell the stock at the strike price.  But who will buy that stock?  The seller of the put has the responsibility to buy the stock at the strike price.  The writer of the put (write is another term for sell) is paid a premium to take on this responsibility and expects the price of the stock to be above the Strike Price on expiration day.  If that is the case, the option will expire worthless and the put writer will keep the premium.  If the stock price is above the Strike Price, the writer of the put will have to buy the stock at the Strike and the premium can be used to offset the cost.

The table is an illustration of writing various puts on Google that will expire on Oct 18, 2008.  The current price of Google is 438 and the 430 strike will expire worthless since no one will choose to sell the stock at 430 when its current market price is 438.  The 440 is above the market price by 2 points and is said to be in the money by 2 points.  The 430 is out of the money.  The October 430 can be sold for 20 and your actual cost for the stock will be 410 (Strike less Premium) which represents a 5% profit (Premium divided by Cost).  There are 35 days left until expiration so the annualized gain on the investment is 51%.  The stock price is now 28 points above the actual cost so the decrease for a loss (DFL) is 28 points or a drop in the stock price of 6%.

The table shows 3 other strike prices, above and below the current price.  You can see that as the Strike Price decreases the potential gain decreases as does the probability of a loss.  Conversely, as the Strike Price increases the potential gain increases and the probability of a loss increases.  Note that probability of a loss is inversely related to how much the stock price must decrease before you will lose money.  The more the stock must decrease the lower the probability of a loss.

This topic will be continued in a further article where I will discuss your alternatives as you approach expiration day and some of the uses of writing a put.

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