InvestorQ : What are the justifications for selling a put option?
vidhya Laxmi made post

What are the justifications for selling a put option?

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diksha shah answered.
2 years ago

When you sell a put option, you are not too negative on the stock. At least, you do not expect the stock to correct very sharply from current levels and expect the downsides of the stock to be limited. At the same time you are not too positive on the stock either because then you would have as well purchased a call option. When do you sell a put option and what is the strike you select. You normally select the strike where you are most likely to retain the entire premium in your hands. For example, if you expect the stock of RIL to bottom out at Rs.1110, then a good strategy would be to sell the Rs.1100 put option so that you can retain the entire premium. Here is when you have a strong case for selling put options.

· A put option is best sold when you believe that the stock or the index is close to bottoming out. You cannot buy a call because you are not yet bullish on the stock. However, you can make the best of the bottoming of the stock by selling puts at a strike that is slightly lower than the level you are expecting the stock to bottom out at.

· Another reason you can sell a put option is when you are expecting the volatility of the stock to fall. If the volatility were to fall, then you can automatically make money as the option premiums will go down anyways. Here, even if the price is static, the fall in volatility will result in a fall in option values.

· Another common reason to play the short put is to get advantage of the Theta game. What exactly is this Theta game? Essentially, theta refers to time decay. Time works against the buyer of a put option but works in favour of the seller of a put option. With each passing day, the time value keeps diminishing and the makes the put option premium come down making the trade profitable to a put options seller.

Lastly, put selling can be very useful in reducing the cost of your short position and improving your breakeven point. Suppose that you sold SBI futures far month contract at Rs.310 but the stock has moved up to Rs.335. However, you continue to be negative on the prospects of the stock due to the huge overhang of NPAs in the banking system led by SBI. In case you need to hold on to the futures position for a period of 3 months; instead of letting the short futures idle in its place, you can keep selling lower puts. Whatever profits are earned on puts sold you take home, reduces your effective cost of holding on to the short SBI futures. In case, the SBI price goes down sharply, you have nothing much to worry on the puts sold because you have the short futures on SBI anyways.