There are plenty of potential option strategies, and one of them is selling puts. In this article, we look at how you can make money by writing or selling puts.
Is selling puts a good trading strategy? Selling puts might be good for you if you know what you are doing, and it could be used in addition to other strategies. It’s hard to conclude whether it’s a bad or good strategy – the beauty is in the eye of the beholder.
Why is the beauty in the eye of the beholder? Because it depends on many factors, your aims being the most important. When you sell a put, you have agreed to buy a stock or index at an agreed price (strike). If the price rises, you can pocket the premium received. Opposite, if the price falls, you might be forced to buy at higher levels than the market. Thus, a put seller might want the market to go up or sideways to avoid having to buy above the market price. Because of this, only you can decide if this is a fit for you.
Let’s start the article by explaining what a put option is:
What is a put option?
A put option is the opposite of a call option (please also read our take on covered calls and the wheel trading strategy). A call option involves the right to buy a stock at a certain price (strike) within a certain time frame (expiration).
A put option has a buyer and a seller. The buyer of a put option takes a bearish view (or uses it as a hedge), while the seller is a bit more optimistic.
If the price of the underlying instrument drops in value, the buyer of the put option can sell at the strike price if the current price of the underlying security is lower, while the seller is forced to buy at the strike price. If the option expires worthless, the buyer has lost the premium while the seller can pocket the premium (and can rinse and repeat).
Puts are almost like insurance: the buyer buys protection, while the seller (insurer) sells the insurance. The buyer has a limited risk (only the premium paid for the option), while the seller (insurer) takes on a much bigger risk because he is forced to buy at the strike price.
Thus, a put option involves the right to sell a stock at a certain price within a certain time frame. You can profit from a drop in price while you at the same time have limited risk (if you buy a put).
If you are selling short, you might face unlimited risk, because a stock can theoretically increase in price endlessly. This is why many prefer to buy puts instead of selling short.
Why would you sell puts?
Let’s make an example of why you would sell (write or issue) puts:
You are currently considering investing in Microsoft shares. The current price is 300, but you believe this is too high, but you are interested in buying if the price was 275.
You check the options market and discover that put options with strike 275 expiring in 9 months are trading at 10 USD.
(This price is just taken out of the air. Option prices are determined by many factors, among them volatility, interest rates, and time. We will not go into details about those factors in this article.)
What does this mean? This means that you receive 1 000 USD when you sell the puts (because one option equals 100 shares). The premium is yours to own. However, you need to put up margin or collateral.
Why would you need collateral? Because you are forced to buy the shares at 275 if the price of Microsoft drops – because the seller has the right to sell at that price (or you can close the put position at a loss). Obviously, at 300, the option is out-of-the-money, because no one would sell at 275 when you can sell at 300. If the option is not exercised within the expiry date, the money is yours to keep. Then you can rinse and repeat endlessly until you sooner or later are forced to take delivery and buy the shares.
Is selling puts a good trading strategy?
If you can rinse and repeat, is this perhaps a possible trading strategy?
First, some words on volatility. Research shows that implied volatility in option pricing is bigger than the real volatility. Because volatility is one of the main determinants of the option price, we might argue that it pays off to sell puts (and not buy because the premium decays over time).
Oleg Bondarenko wrote a paper on how to sell put and its performance a few years back called An Analysis Of Index Option Writing With Monthly And Weekly Rollover. Despite the article’s relatively difficult headline, the results are quite interesting. Bondarenko’s research concluded that real volatility was 15% while the options’ implied volatility was a lot higher at 19.8%. The study covers 1990 until 2015:
Does this matter when selling puts? Yes, because the more volatile an asset is, the more it will cost to insure. If the implied volatility of the put option is greater than real volatility, it might be a good idea to sell puts and not buy puts.
Let’s continue by looking at what Oleg Bondarenko tested in his research:
Facts about selling puts
Bondarenko looked at put options in the S&P 500. Once every month or week, he sold puts that were at the money.
Oleg Bondarenko’s research reveals some interesting stuff:
- Historically, the option implied volatility has considerably exceeded the realized volatility of the S&P 500 index.
- High volatility premium indicates that the index options are richly priced. As a result, put writing strategies have historically delivered attractive risk–adjusted performance (read more about trading strategy performance metrics).
- Selling 1–month ATM puts 12 times a year can produce significant income. From 2006 to 2015, the average monthly premium is 2.01%.
- Selling 1–week ATM puts 52 times a year can produce even higher income, but transaction costs can be higher with more frequent trades. From 2006 to 2015, the average weekly premium is 0.75%. Although smaller, the premium is collected more frequently.
Selling puts indices
Chicago Board Of Exchange has two theoretical indices that track the performance of a hypothetical passive strategy that collects option premiums from at–the–money (ATM) options on the S&P 500 Index, and holds a rolling money account invested in Treasury bills. The ticker codes are PUT (monthly rollover) and PUTW (weekly rollover). By owning the underlying index you have a so-called cash-secured put. PUT was launched in 2008 and WPUT in 2015.
An example of selling puts strategy
According to Bondarenko, a theoretical performance of buy and hold, monthly rollover, and weekly rollover would look like this:
As you can see, the total returns are somewhat lower than S&P 500, but you experienced smaller drawdowns along the way because you constantly received “income” from the sold put premiums. Lower drawdowns might result in fewer behavioral mistakes in trading.
Is selling puts a good trading strategy? In practice and live trading
In 2016 the fund manager WisdomTree launched an ETF that tries to copy the monthly rollover strategy by issuing at the money puts. The ticker code is, of course, PUTW and the full name of the ETF is WisdomTree CBOE S&P 500 PutWrite Strategy Fund.
We can easily track its performance compared to the S&P 500:
The first pane is the share price of ETF (PUTW), while the lower pane is its relative performance to S&P 500 (we used SPY as a proxy). As you can clearly see, since its inception in 2016 PUTW has underperformed.
However, when the market drops we can see that writing options lead to less damage (it outperforms). Writing options will underperform in a bull market, but will work well in a market that goes sideways or down because the option premium offsets some of the losses.
Risks of selling puts
Selling (or issuing) puts in a sideways or bear market will outperform buy and hold. Opposite, in a rising market the strategy will most likely underperform.
Nevertheless, when you write puts you need to take delivery if the price of the stock goes lower than the strike price. For example, if the strike price is 100 and the price of the underlying asset is 90 at expiry, you are forced to but at 100. That is a loss of ten. On the plus side is that you have received an option premium that offsets loss.
Additionally, you are liable to taxes on the option premium you receive, and also taxes on capital gains of the underlying asset (if you have gains).
However, if you are a long-term investor and believe that the current price of your stock is too high, it might make sense to sell puts with a lower strike. You get the premium (you get “paid” to wait) and you are probably happy to buy at the strike price.
Is selling puts a good trading strategy? Conclusions
Thus – Is selling puts a good strategy? It depends. Beauty is in the eye of the beholder. Selling puts might be good for you if you know what you are doing, and it could be used in addition to other strategies.
Is selling puts a good trading strategy?
Selling puts involves agreeing to buy a stock at an agreed price (strike) and can be a strategy to generate income in the options market. Whether selling puts is a good strategy depends on various factors, including the trader’s knowledge, goals, and risk tolerance. It can be effective if used appropriately.
Why is selling puts considered subjective?
A put option grants the right to sell a stock at a specified price within a certain timeframe, offering a bearish view. The suitability of selling puts depends on individual factors and trader goals. The beauty of the strategy is subjective and varies based on aims and risk appetite.
Why would someone choose to sell puts in the options market?
Traders might sell puts to generate income and potentially buy stocks at a lower price. It can be used when the trader has a target purchase price below the current market value. Higher implied volatility can make selling puts more attractive, as it increases option premiums. Traders may consider volatility as a factor when deciding to sell puts.