This is an exciting article to write for several reasons. The biggest reason is that the art of selling a put has generated tons of money for GKT traders. It is also an extremely simple strategy! Because selling a put is an option trading strategy in itself, we will discuss it briefly in this article. However, this article will focus less on the nuances of this strategy but primarily will provide a foundational understanding of what happens after a put is sold.
Just in case you missed it, or if you aren’t really sure what a put option even is, check out this article which gives a big picture overview of options trading as a whole.
But first… a quick review!
Put Options Explained
The put option gives the buyer the right to sell 100 shares of stock at the strike price on or before the expiration date to the put option seller. The buyer can choose to execute this right at any point in time up to the close of the market on the expiration date. The seller of the put option is obligated to buy the shares if this happens. The put seller simply has no say in the matter.
Biggest Mistake with SELLING Put Options
The biggest mistake with selling put options is forgetting the obligation that you signed up for. Read the section above again if you don’t know what I’m talking about. If the buyer of the put chooses to sell you shares, your broker will automatically buy them for you with your money and will send you an email afterwards to let you know.
People make this mistake when they become too greedy or overly confident that they’ll be correct. It takes exactly one extra keystroke to sell 10 put options than it does to sell 1 put option. If you sell one put at a $30 strike, you need to be mentally prepared to spend $3,000 to buy 100 shares of stock in the worst case scenario. If you sold 10 puts, you’d need to be ready to spend $30,000 dollars.
Don’t let this scare you though! GKT would be doing you a massive disservice if we didn’t warn you about the risks that come with a trade. You should also keep in mind that I said selling puts consistently generates a lot of money for the GKT community as a whole.
Selling a Put Option Example
If you are not totally scared off at this point, and good on you that you aren’t, we will break down selling a put using an example.
This image is from the tastytrade broker but all brokers should look somewhat similar.
In this example (which is used for illustration purposes only and should not be considered trade advice), SPY was trading at $411.83 and we decided to sell one of the 400 puts in SPY in the May 19, 2023 expiration cycle. When you sell a put, you collect the premium which in this case was $3.20 per share or $320 dollars total.
When traders talk to each other they may say, “I’m short the 400 SPY put in May for $3.20.” Check out this article if you need a refresher on going short.
And now we wait. While we are waiting…
Worst Case Scenario when Selling Puts
In our example we sold the $400 SPY put. Regardless of how unlikely it may be, SPY’s price can theoretically fall to $0 per share. If this were to happen, the put option buyer would force us to buy 100 shares of SPY at $400 a share. At this point we would spend $40,000 to buy something totally worthless. Again, this is the WORST case scenario but you should always know the risks you are taking with each trade.
How do Short Puts Make Money?
Put option sellers make money when:
The stock’s price goes up
The stock becomes less volatile.
Put Option Sellers Make Money as Price Goes Up
When we opened the trade, SPY was trading at $411.28 per share and we sold the $400 put. On May 19th, if SPY closed at $400.01 or higher, it wouldn’t make financial sense for the put option buyer to sell shares at $400 when they could sell those shares for $400.01 or higher. Our put option would then expire worthless and we would keep the entire $320 of premium we collected by selling the option.
Astute readers, like you, probably caught the misleading title of this section. Put option sellers will definitely make money if the price goes up. AND they can also be profitable even if the price goes down, so long as the price at expiration closes above the sold strike!
I hear you asking, “Are you telling me that if SPY went down to $0.00 then back up to $400.01 at expiration, we’d keep the $320 in premium?” My answer is 100% ,“Yes!” but you’d probably be incredibly sick to your stomach along the way.
As the price of SPY falls, the put option buyer’s trade starts working and all the mechanics that make their trade profitable explain why your trade would be losing. Only one of you two can win on this trade after all is said and done. Briefly, they can sell you shares at the strike price and immediately buy them back for less than what they sold it for. If you didn’t catch that article, check out the basics of buying a put option for a full explanation of this concept.
Put Option Sellers Make Money as Time Passes
This title is not misleading at all. The literal passage of time decreases the value of an option. Compare our example to this picture.
Both pictures show a put sale at the 400 strike in SPY. Our initial example sold the 29 days to expiration (DTE) option and this picture sold the 14 DTE option, which is roughly half the length of time. For you math sticklers, it is 51.72% less time.
Notice how the price of this put sale trades for $1.53, which is highlighted in the green box. This is roughly half of the price of the initial example, which was $3.20, or a 52.5% reduction in the premium.
This example highlights the time component of options pricing. Simply stated, the more time left in the option, the more value it retains. As time passes, the amount of time left on the contract decreases, which in turn decreases the value of the contract.
Some really smart people who are really good with a calculator created a formula to quantify how much an option’s value will decrease with each passing day. This value is called Theta and is represented by the blue box in the picture above.
Theta = Time Value
In this example, the option’s price should theoretically decrease by $0.12 over the next 24 hours. Time value is only one variable in the option pricing formula. The price of the stock and volatility are also variables within that same formula. Stock price and volatility are never constant in the real-world which is why Theta is a theoretical value.
The biggest take home here is that put option sellers, and option sellers in general, benefit from the passage of time because the time value included in the option’s price will decrease.
Put Option Sellers Make Money with a Decrease in Volatility
The third way for put option sellers to make money is with a decrease in the volatility of the underlying stock.
Option Volatility Explained
Option volatility is a fancy way to say “uncertainty.” To illustrate this concept, think about your average trip to the grocery store. Each time you go, you pretty much know how much a box of cereal, loaf of bread, can of soup, etc., costs. Sure it may go up or down a few pennies, maybe even a nickel, before you notice. The consistency of price allows you to be pretty certain of the value of the product. When it goes on sale, you don’t hesitate to buy it. The volatility of price in your average grocery store is low.
Now imagine a grocery store where the price of items changes massively every visit. One time a dozen eggs costs 20-30% more than it did previously. The next time, the price of eggs falls 50%. Now fresh produce is up 25% and that carrot is worth its weight in gold. I can’t speak for you, but I would probably take my business elsewhere because I couldn’t handle the price swings. This would be a highly volatile grocery store.
In the stock market, volatility is correlated with uncertainty in the future price. Blue chip dividend stocks like Coca-Cola (KO), Procter & Gamble (PG), and Wal-Mart (WMT) more or less chug along. Every now and then they will have a big price swing, but these swings typically correspond with broader market movements, like the COVID crash in March 2020. As a result, people more or less “know” what they are getting into. A low volatility stock’s price movement is about as exciting as a children’s roller coaster.
Highly volatile stocks like Tesla (TSLA), Square (SQ), and most of your growth focused companies are similar to the adrenaline pumping roller coasters with the mechanical ratcheting sound as you go up, fast drop, and some combination of loops and spins to follow. Good news one day sends the price soaring and mediocre news can plummet these types of stocks. Sometimes, good news can drive the price down and bad news sends the price up. No one said the market was rational.
Keeping with the roller coaster analogy, no stock’s volatility is ALWAYS high or ALWAYS low, just as there are faster and slower parts of every roller coaster. Eventually the stock’s volatility will work its way back to its “normal” just as a rollercoaster always returns to the start.
Option sellers try to take advantage of times of increased volatility. When volatility is high, the price of the option is also high. When volatility decreases, the price of the option similarly decreases. Option sellers want to sell the option when volatility, and therefore the option price, is high with the intent to buy it back when volatility, and the option price, has decreased at some point in the future.
How To Manage a Short Put
When you sell a put, you have no say over whether or not the buyer will exercise their right to make you buy shares. Unless the sold put is extremely in the money (ITM) and close to expiration, or a dividend is coming, the likelihood of the buyer exercising their put is very low.
I’ve said it once and I’ll say it again, you should be mentally prepared to buy the shares at the price you sold the strike from day one!
How to Manage a Short Put that is Profitable
This is the most ideal and hopefully the most common scenario that you’ll find yourself in. You sold the put then time passed, price went higher, volatility decreased, or some combination and now the put is worth less than what you sold it for. Congratulations on your winning trade!
The easiest thing you can do is buy back the put for less than you sold it for. At GKT, we tend to close out winning sold puts at 50% of the credit received. We use Good Till Canceled orders, or GTC’s, to do this for us automatically. In our example where we sold the 400 SPY put for $3.20 expiring on May 19, 2023, we would typically set a target to buy it back for $1.60. There are times where we may deviate from this course and hold for more or bail out for less. There are times where we even cut our losses and run! You can and should write a trading plan to help you guide this decision.
How to Manage a Losing Short Put
Managing losing trades is one of the most important parts of investing in the stock market. I hate to break it to you, but you will find yourself with losing trades. In fact, you’ll find yourself with a LOT of losing trades. Some traders wipe out all of their gains, and sometimes more, with their losses. Profitable traders expect to have losing trades and they have a plan to help them lose as little as possible.
With short puts you have a couple management options available. There isn’t one right answer for every situation and you should be familiar with each option
Close the option for a loss. Although this doesn’t sound fun, sometimes it is best to just cut and run before the losses get bigger. Some people are only comfortable losing so many dollars on a given trade. If that number comes up, they exit the trade and move on. This is a very sensible way to keep losses small.
Roll the option out in time. Rolling an option just means closing out the current trade and opening up a new one in the same underlying. To roll a short put, you’d buy it back and then resell it again. When managing short puts, you’d most commonly roll out in time. We initially sold the $400 SPY put in May, so we could buy it back and then sell the $400 SPY put in June. Typically, rolling out in time will result in a net credit. You may buy the option back for $2.00 and would sell the $400 put in June for $3.00, resulting in a $1.00 credit.
Roll the option out and down. In this scenario you are rolling out in time like we just described but now you are trying to roll the strike down. So you’d roll from the $400 SPY put in May to the $395 SPY put in June. Again, you’d ideally like to take in a net credit. Since you are lowering your risk by decreasing your strike, the credit may be small. If you try to roll too far down, you’ll see it starts to cost a debit. We generally try to avoid paying a debit because it takes away from the profit potential of the trade but sometimes it is necessary.
Wait. Waiting is a tough thing to do when you are staring at a loser in your account. As I’m writing this article, I have two short put losers in my account. Given my plan and where I am in the trade, I plan on waiting for time to pass and hoping for a favorable move in price. No one knows what the future will bring, but at minimum time passing is certain and I will collect some Theta. As we outlined above, as time passes, the option gets cheaper from that one perspective. Price falling can certainly outweigh the benefits of time passing which is the biggest risk with this style of management.
This article provides an overview for selling a put option and outlines some of the fundamental concepts. This article also gives a taste of the strategy of selling a put. For the final time in this article, the most important thing to remember with selling a put is that you have to be prepared to buy the shares at the strike price. It is really easy to sell more puts than your account size can handle.
As long as you manage the risk inherent with selling puts, this can be an extremely powerful tool for building wealth.
Feel free to leave any questions in the comments below. If you want to see how GKT sells puts in real time, join our discord community today!