Closing a Sell Put Option Early: When and How?

Have you ever considered closing a sell put option before it expires? You might be surprised to learn that it's indeed possible to do so, and it offers both advantages and challenges. In this article, we will explore when it makes sense to close a sell put option early, the process involved, and the potential outcomes.

Understanding a Sell Put Option

A sell put option, or a short put, is a strategy commonly used by traders and investors in the stock market. When you sell a put option, you are essentially committing to the obligation to buy a certain underlying asset (stocks, index, etc.) at a specified strike price if the option is exercised by the buyer. This strategy is particularly useful for selling naked options, meaning that the trader does not own the underlying asset initially. However, this also introduces a significant amount of risk.

When Would You Close a Sell Put Option Early?

There are several reasons why you might choose to close a sell put option early:

Profit: If the value of the option has decreased, you can buy it back for a lower price, thus locking in a profit. Limiting Risk: If the market moves against you, you can close the position to prevent further financial losses. Avoiding Assignment: If the option is in-the-money (ITM) and you do not want to be assigned shares, you can close the position early to avoid this risk.

The Process of Closing a Sell Put Option

Closing a sell put option involves buying back the option contract, which is known as buying to close. This action nullifies your original obligation and allows you to exit the position.

Example: Selling and Closing a Put on AMZN

Suppose you sell an Amazon (AMZN) put option with a strike price of 147 and a two-week expiration, collecting a premium of 2.73 per contract (273 per contract). This is a bullish trade, as you hope the option will expire worthless out of the money, with the underlying asset above the strike price.

You can buy it back (buy to close) before the expiration, but you will give up some of the premium you initially collected. If AMZN remains above 147 and you decide to buy it back one week before expiration, you could give up some of the premium. For instance, if you give up 2.00 of the premium, you will only retain 0.73 per contract.

Comparing Naked and Spread Strategies

A naked put, as explained earlier, carries inherent risks due to its unlimited downside. If the stock price moves significantly in your disadvantage, your losses can be substantial. For example, if AMZN trades at 120 a month ago and revisits that level, you would be in a precarious position, with potential losses of up to 2400 at expiration if the stock price falls to 90, the level it was in March 2023, you could lose around 5400.

However, a safer strategy involves using a spread, such as a bull put spread. This strategy involves selling one put contract and simultaneously buying one at a lower strike price with the same expiration. This reduces your risk by offsetting the potential losses with the premium you collect.

Bull Put Spread Example: AMZN

Using the same AMZN example, you sell a put with a strike price of 147 and a two-week expiration, receiving a premium credit of 2.78. You then buy an AMZN put with a strike price of 146, paying a debit of 2.31. The net credit to your account is 0.47 per contract.

As long as AMZN stays above 147, both contracts will expire worthless, and you keep the 0.47 per contract. The long put acts as a hedge, providing some protection if the stock moves in the wrong direction. Your maximum loss is limited to 0.53 per contract.

Conclusion

Whether you decide to close a sell put option early or opt for a safer spread strategy, it's crucial to manage your risks effectively. A bull put spread offers a balanced approach to selling put options, providing both ongoing profit opportunities and limited downside, making it a valuable tool for any trader seeking to manage risk and achieve financial goals.