Selling Index Puts

[Igor 10]

Traders who sell index puts are betting that the market price of the index's underlying value will go up. The strategy involves selling a put that's associated with a stock market index. The index plays the same role as an underlying asset does in normal options trading. Investors settle their exercised index options in cash, so there are no assignments of assets. When traders sell index puts, they forecast that the option will expire OTM and worthless. The most a trader can gain is limited to the amount that he or she receives in premiums. At the same time, there is no limit to how much an investor can lose, since the potential decline of any stock index is infinite.

 

Definition of ATM, ITM and OTM for Puts

There are three ways to define the relationship between an option's strike price and the market price of the underlying index. Understanding the differences between the terms is important because the risks involved in selling index puts depend on these terms at the time of the sale and when settling for cash.

 

 

ATM - At The Money: The underlying index's market price equals the option's strike price.

Example:

- Put Option DJX400 (strike price $400)

- Index DJX is trading at $400

 

ITM - In The Money: The underlying index's market price is less than option's strike price.

Example:

- Put Option DJX400 (strike price $400)

- Index DJX is trading at $380

 

OTM - Out of The Money: The underlying index's market price is more than option's strike price.

Example:

- Put Option DJX400 (strike price $400)

- Index DJX is trading at $420

 

How to Sell Index Puts (ATM)

The DJX is worth $400 (market price)

1) Trader writes (sells) an index put option: DJX400($4)

- One Option with a contract multiplier of $100

- Strike Price $400 (ATM)

- Premium Cost of $4

 

2) Trader receives $400 in premiums (100 x $4 (premium cost)).

 

Result one: DJX hits $380 (ITM). The put buyer exercises his or her right to sell 100 shares at $40. The difference between the option's strike price and the DJX is $20 (Option $400 - DJX $380). Since there is no assignment of assets, the trader settles in cash for $2000 (100 x $20). The investor's total loss is reduced to $1600 after adding premiums received.

 

Result two: DJX hits $420 (OTM). The put buyer lets the option expire, does not exercise his or her right to sell and loses the amount of premiums paid. In this example, the writer would profit $400 (premiums paid).

 

Advantage and Disadvantage of Selling Index Puts:

 

Pluses: The upside to selling index puts is that the investor can enter the market without paying cash. They in fact are issuing an IOU, hoping that the obligation will expire worthless.

 

Minuses: The downside is that a trader's profits are limited to only the premiums received from the put buyer. Also, the potential loss risk in selling puts is unlimited, as an index can decline up to a zero value.

[BlueHorseshoe 10]

So who sells options, why do they do it, and how (if at all) do they go about limiting risk?