- May 21, 2018
- Posted by: fortunatetrader
- Category: Trading 101
What is a Call option and a Put option and how does it work? — Part4 – SELLING a PUT
Make sure you understand what the options are first: What is an Option?
Welcome to the third article of the series.
We have learned in the last two articles how to BUY a CALL and a PUT
What is a Call option and a Put option and how does it work? – Part1 – Buying a CALL
What is a Call option and a Put option and how does it work? – Part2 – Buying a PUT
There are two different kinds of options: CALLs and PUTs.
And we can either BUY or SELL them
The four possible actions to do with options:
-BUY a CALL
-BUY a PUT
-SELL a CALL
-SELL a PUT
When you sell a CALL option you have the OBLIGATION to SELL the stock (or underlying) to someone at a defined price during a specific amount of time in exchange of a premium.
But why would I want to SELL a PUT?
What is selling a PUT option?
Selling a PUT option is having the OBLIGATION to BUY something from someone at a defined price during a specific amount of time in exchange of a premium.
As a seller of a PUT you expect the underlying asset to go above the defined price before the expiration date.
Again, same example as Part2: The Audi example.
Instead of being the buyer of the insurance, let’s be the insurance company.
You are offering a contract to a buyer that obligates you to reimburse the total value of a $100 000 2018 Audi RS 7 Sportback Performance in case of an accident. In exchange for your commitment, you ask a monthly fee of $100.
You are signing a contract with a buyer (client) that is going to hand you a check for the service of insuring his sport car.
What you are saying to the client (buyer) is: “In exchange of a $100 payment right now, I commit to cover any kind of damage and if the car gets in an accident or goes to a total loss, during this month.”
So what will happen if the $100 000 goes to $0? Because you have an insurance policy, called here a PUT option contract, you are forced to honor your obligation; to pay the total value of the car, $100 000.
What’s in it for you?
You receive $100 a month and if the client doesn’t get in an accident, you get to do the deal all over again.
What’s in it for the buyer?
The client gets protection from a loss and you are forced, the insurance company, to buy it in case the client does get in an accident.
That is selling a PUT option.
Do you understand why insurance companies make so much money?
It’s because they are always collecting.
Why selling a PUT option in the stock market?
You can sell protection to someone so there is an obligation to BUY something at your desired price.
In brief, you think that the market will go up; that the market will be bullish. That’s why you are selling a PUT option contract.
Again, Again… the house example.
You are renting for a while and want to acquire something. You look in a specific location but you are not in a rush.
The average house price is around $180 000 in that area.
While talking to your brother, over Thanksgiving, he suggests that you call one of his friends that is actually selling his house in that neighborhood for $180 000. He told you that the guy really needs to sell because he is moving to Indonesia in a year.
While driving home you pass in front of the house and fall in love with it. As soon as you get back home you call the guy: “Good afternoon Sir, I like your house, I’m willing to buy it right now for $160 000.”
The owner needs to sell but prefers to try the market; the actual market offers $20 000 more.
You really want the house but don’t want to pay more than you suggested, so you make a deal with the owner.
“Because I like your house I can wait for you to decide if you are going to sell it to me and I won’t shop around. Because of my commitment, and as an insurance for you, I will ask you to give me $1 000 right now. So if you are not able to sell it at the price that you want you will have me obliged to buy it from you just before leaving for Indonesia.”
The owner accepts.
I then receive $1 000 right now to have the OBLIGATION to BUY the house in the year at the define price.
So after a year, the market drops the price of the house to $140 000 because there were three criminal incidents during that period in that area.
The owner (buyer of the PUT) will exercise his RIGHT and force you, the WRITER, to buy his house at the discussed price of $160 000. Well done ice climber!
“But what if the house market stays the same or even worst, goes up in price and the house gets to $220 000 instead of going down?”
If that occurs, the buyer mightn’t want to exercise his RIGHT.
Why sell something at 160K that is now worth 220K?
He might want to just let the contract expire and sell it at the actual market price.
Remember? We had settled the contract period for a year.
You will have made $1 000 but won’t have bought something that is worth more actually, or what we call “Out of the money” for a PUT buyer.
You will have lost a potential profit of $40 000 if you would have just bought the house for $180 000 but you did make $1 000 for just committing to purchase at a way better price.
Technically, even with the actual market price of $140 000 you are happy because you have done your homework and you know that the value of this house is over $160 000. It is very important to understand the difference between PRICE and VALUE. We will cover this in another article.
Today we have learned about one of the four ways of trading options: selling a PUT option.
In short, a PUT option is called a “PUT” because the owner has the right to “put the stock away” from the seller. It is also called an option because the owner of the contract has the RIGHT, but not the OBLIGATION, to SELL the stock at the strike price. In other words, the owner does not have to exercise the option and sell the stock. If selling the stock at the define price is unprofitable for him, the owner of the PUT can just wait the predetermined timeframe and let the option expire. But if it is the case where the buyer sees an opportunity for profit, he can force the seller to BUY at the defined price. In this case, the seller of the PUT will be assigned the shares.
– Make It Happen –