Why sell a short put at a strike price above current price of the underlying?

Question

I understand that selling a put below the current market value provides:

1. A premium paid up front
2. A chance to buy stock at a lower price

Item 1 achieves its maximum gain if the price of the underlying is above the strike price at expiration. When looking at my put sale options on stock XYZ currently trading at $85, why would one want to sell a put at a strike of $95 with a premium of $22?

If one contract was sold, $2200 would be the premium received for selling to open the contract. However, the moment somebody bought that contract, the strike price was above current market value, ITM, and thereby could be exercised. That means it could be assigned for ($95 * 100) - $2200 = $7300 owed.

Why would that even be an option?

Answer 1

When you sell a short put, you pick the strike price that offers the balance of profit potential and risk that best suits you. The deeper OTM the put is, the lower the profit potential and the more the the underlying can drop before you are at risk.

If you are neutral to bullish, you can sell an ATM put which offers a larger premium and greater profit potential but has no downside buffer other than the premium received.

If you are bullish, you can sell an ITM put, receiving more intrinsic value (but less time premium). The profit potential is greater than the above scenarios. The more bullish you are, the higher the strike price that you sell.

In your example, with the underlying is $85 and you sell a $95 put for $22, you have a potential profit of $12, a buffer of $10, and a cost basis of $73 if assigned. $73 might be exactly what an investor is willing to pay for the stock hence that put is the chosen one.

Your concept of the moment somebody bought that contract, the strike price was above current market value, ITM, and thereby could be exercised is incorrect. Your put has $12 of time premium. Exercising it would throw that away so it's better for the owner to sell it rather than exercise it. Theoretically, any short put seller receiving $12 of time premium would be happy to be assigned right away. Buy the stock via assignment and sell a $95 covered call (which would be equivalent to selling the stock and immediately selling another $95 short put to open). Don't get your hopes up. This rarely happens.

Answer 2

Your calculation is incomplete. You would essentially trade $7300 for stock worth $8500. So you could sell the stock for a $1200 profit in your scenario.

Steps are as follows:

1. You receive the $2200 premium
2. The option is exercised so you pay $9500 to the option-holder for 100 shares of the stock. Your cash balance is now $7300 less than when you started but you now have 100 shares of the stock.
3. You sell the 100 shares for $8500. Netting a profit of $1200.

Note that when you sell put options, you will always pay more than the FMV at the moment the option is exercised. If the strike is below the FMV, the option will not be exercised. You make your profit selling options from the premium. The same is true in reverse when selling call options. The option will only ever be exercised if the FMV is higher than the strike.