Hi all, I'm just learning about options. I want to propose an example, written in my own words, and have someone tell me if I understand this correctly or if I made a mistake somewhere.
Basically, you sell puts against XYZ with a strike price lower than the current price because you think that in the near term the price will go down, but in the long term you think the price will go up. In selling the puts, the buyer pays you a premium for each share. If the buyer exercises, then he is selling you shares at the strike price, which you are required to buy.
On the buyer side, he is believing that XYZ will fall further. Indeed, buying puts is akin to shorting a stock. For example, if you sell $18.00 strike puts at a $2 premium and someone buys them, this essentially means he thinks the stock will fall below $16. If it does, he will exercise the puts, forcing you to buy stock at $18 and he pockets the difference.
1) The buyer exercises the options because it's advantageous to him. You now pay $18 (for example) for XYZ shares which are trading on the market at <$16. Big deal though, either one is an amazing price (in your mind), plus you keep the premium, so effectively you paid $16 / share. And now you got cheap XYZ stock with virtually 0 risk of missing out on the good deal.
2) The option expires because the buyer was wrong, it never goes down below $16. You have spent nothing, in fact you have made money (the premium that he paid you for the put).
- Let's make the example more concrete with more numbers. I sell 10 XYZ puts with a strike of $18 and a premium of $2. Since 1 option contract is 100 shares, this is actually 1,000 shares worth of XYZ.
- In order to do this, I am putting myself on the hook for potentially buying $18k worth of XYZ, so $18k of margin is set aside by my brokerage and made temporarily inaccessible to me.
- Someone purchases my 10 contracts for $2 / share, so $2k is just automatically deposited into my account and I have spent nothing yet.
- If, at any point during the option period, the buyer exercises, the shares are paid for with the set-aside margin and now I have 1,000 shares of XYZ in my account @$18 each.
- If the option expires, my margin is made usable again and I'm up an additional $2k.
As long as you know the price will go up long term, this is a win-win situation for you. The way you lose this trade is if the buyer exercises the option but the stock does not recover from its low price.
You make money selling puts if:
You lose money selling puts if:
- The price of the stock falls, causing the buyer to exercise, and then the price of the stock goes back up. You then have cheap stock and make money the way you normally do with stock, by selling it high.
- The price of the stock does not fall and the option expires, in which case you keep the premium.
- The price of the stock plummets, causing the buyer to exercise, but the price does not recover and you're left with shit stock.