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Understanding Stock Options - Part Five

By Edited Feb 21, 2014 0 1

In part two and part three of the series we discussed call options.  Part four covered the purchase of a put option.  Now in the last installment we will take a look at the selling of a put option.

When you purchase a put option, it gives you the right to sell a stock at a certain price known as the strike price.  So the opposite is true when you sell a put option.  By selling a put option you have the obligation to purchase the stock at the specified strike price.  In other words since the buyer has the right to sell the stock if it goes down, then the seller has the obligation to pay the buyer for the stock.

How Selling a Put Option Works

When you sell a put option you are collecting a premium for taking the risk that you might have to purchase a stock at a price higher than where it is trading at expiration.

Let’s say you sold a put option for 50 cents in June on XYZ Company that gives you the obligation to purchase the stock at the strike price of $20 in August.  August rolls around and the stock is trading at $10.  You now have the obligation to purchase the stock of XYZ Company at $20 even though it is only trading at $10.  You have taken a big loss because of the sale of a put option.

However if the stock of XYZ Company is trading at $25 then the buyer of the put option is not going to exercise their right to sell you the stock at $20 when they can sell it for $25.  So you get to keep the premium you received for selling this put option as all profit.

Reasons for Selling a Put Option

Most people who sell put options are just speculating.  The market may be rising and they have no fear that it will go down so they sell put options with the hopes that stocks will keep rising and they will just get to keep all the premiums they receive.

The most overlooked reason to sell a put option for the average investor is to purchase stocks at a cheaper price.  The only way this should be done is if there is enough money in the account to pay for the stock should the buyer of the put option exercise their right to sell to you.

How this works is say you want to own stock in XYZ Company and it is trading at $20.  You sell a put option for 50 cents.  If you have to purchase the stock then you are actually purchasing it for the net price of $20 for the stock less the 50 cents you received for selling the put option, thus creating a purchase price of $19.50. 

I believe this is a very good way to purchase stocks for a lower price.  Hopefully now that you understand how options work you can find a few stocks you want to own and try to purchase them at a lower price.

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Comments

Mar 9, 2011 12:00pm
bh25
Anybody who reads this if you could tell my why the #13 keeps getting stuck in my titles I'd appreciate it. Thanks.
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