Introduction to Selling Put Options
When it comes to investing, there are many different strategies that you can use to grow your wealth by trading stocks and options. One such strategy is selling put options. While this approach can be more complex than simply buying and holding stocks, it is relatively simple compared to many other options strategies such as selling strangles or straddles. It can also offer significant benefits for experienced investors who have a large capital by utilizing a portfolio margin account. I personally have tested selling put options with a portfolio margin account and I must say it was a game changer.
Now, as for the question of “It is possible to make a living by selling put options?”. Well, it requires a significant amount of discipline. Selling put options but its success depends on various factors such as market conditions, economic trends, and individual stock performance. I personally sell put options to collect premiums for the stocks that I do not want to own. I also sell put options for stocks that I want to own or don’t mind owning for the long term.
In this post, we will explore how to sell put options, including the mechanics of the trade, identifying profitable trades, managing risk, and more.
One thing to note, while I do use options in my long-term investment account, my key focus is to trade options for profit so the experience I share below is based on “trading” in mind rather than “investing”.
Buy vs Sell Put Options
Put options are financial instruments that give the buyer the right, but not the obligation, to sell a stock at a specific price (known as the strike price) by a certain date (known as the expiration date).
When you sell a put option, you take on the obligation to buy the stock at the strike price if the buyer decides to exercise their option.
When you buy a put option, you gain the right to sell the stock at the strike price to the put options seller.
Selling put options can be a way to generate income (if the put option expires out of the money) and take advantage of market volatility (implied volatility is an important concept when it comes to selling options as it is incorporated into the option pricing).
How Put Options Work
Before diving into how to sell put options, it’s important to understand the basics of how these contracts work. When you sell a put option, you agree to purchase the underlying stock at the strike price if the buyer decides to exercise the option. In exchange for this obligation, you receive a premium, which is the price the buyer pays for the option. The premium is your profit if the option expires worthless or if the stock price doesn’t drop below the strike price. If the stock price does drop below the strike price, you will have to buy the stock at the strike price, which could result in a loss.
To give an example, if XYZ stock is trading at $100 right now and you expect it to go up. Let’s say at the money put option price costs $5 and you decide to sell it. This would mean at the expiration of the option, if the stock price is higher than $100, you would pocket $5.
On the other hand, if the stock goes below $100 (let’s say $90), you will have to buy it for $100. This means you lost $10, but since you were already paid $5 for the options premium, the net loss was $5. So, you essentially bought the stock for $95.
When to sell Put Options?
If you expect the price of a stock to go up, the selling put option could be a great way to make a profit. If you plan to hold the stock for the long term, look for a close to at-the-money option, or even in-the-money option to make sure you will get assigned. If you want to profit from options premium, selling out-of-the-money options would make more sense.
Is Selling Put Options Profitable?
Yes, it could be profitable but the profit potential will not be as significant as buying put or call options.
To sell put options profitably, you need to identify stocks that are likely to remain stable or rise in price. If the stock price drops below the strike price, you will be obligated to purchase the stock, so it’s essential to choose stocks that you wouldn’t mind owning at the strike price. When evaluating a stock, consider factors such as the company’s financials, industry trends, and recent news.
(Note: Selling Put is also known as the first step of the Wheel Strategy.)
You’ll also need to choose a strike price and expiration date for the put option. Generally, the farther away the expiration date, the more expensive the put option will be, but it will also provide you with more time to ride out market fluctuations. The strike price should be below the current market price of the stock but not so low that you wouldn’t want to own the stock at that price.
Is Selling Put Options Safe?
While selling put options can be a lucrative strategy, it is also important to manage your risk. Below is a list of considerations people typically talk about when it comes to managing risks. While the list contains good advice, I am going to add my own thoughts based on my experience.
1) Setting Stop-Loss Orders
A stop-loss order is a predetermined exit point that is set when entering the trade. This order automatically sells the option if the price of the underlying stock drops to a certain level, which can help limit potential losses.
While this is a useful tactic to mitigate a large loss, I personally do not like setting a stop-loss when it comes to trading put options.
Options pricing can be influenced not only by the underlying stock price movements but also by implied volatility. This means even if the underlying stock price did not move much if the market condition is in a high fear state, options pricing could increase significantly and hit the stop-loss price.
2) Diversifying Trades
Traders can diversify their trades across different stocks and sectors to help spread their risk. This can help mitigate the risk of one particular stock declining and causing significant losses.
I have tried this before, but it is easier said than done because depending on your trading style, especially if you are using options screeners, it is quite easy to find yourself holding options of underlying stocks in the same sector.
3) Adjusting Trades
If the underlying stock price drops below the strike price, traders may choose to adjust their trade to limit their losses. This could include buying back the option at a loss or rolling the trade to a later expiration date.
Ideally, we should have a trading plan laid out before a position is opened. I would do both fundamental and technical analysis to pre-determine at what price point I would just close the position. If the stock price doesn’t hit the price, I would just hold it. Keep it simple.
4) Understanding Margin Requirements
Traders should be aware of the margin requirements for selling put options. Margin is the amount of money required to cover the potential losses from selling put options, and brokers may require traders to deposit additional funds to cover potential losses if the stock price drops significantly.
If you are trading with a cash-secured account, the margin is not an issue because the short put position is covered by the amount of cash you have in the account.
If you are trading with a margin account, then understanding how the movement of the underlying stock price could affect the margin requirement is important.
For example, a larger margin is required for more volatile stocks and from time to time, brokers would decide to change the margin requirement to full cash secured. I have come across this situation from time to time and the learning from that is to keep the position small and leave enough trading power in the account. NEVER use 100% of the trading power.
5) Analyzing Technical Indicators
Traders can use technical analysis to help identify potential risks and opportunities. This could include evaluating the implied volatility of the option, the option price, and the overall trend of the underlying stock.
This is probably the best advice on the list. Especially if you are trading options and not using options as a part of your investment strategy. (Note: Investing and trading are two different things in my opinion).
I do strongly recommend learning about technical analysis if you have not done so.
Best Stocks to Sell Put Options
If you are just starting out trading options, I would recommend selecting stocks that you do not mind owning to sell put options. Avoid picking stocks (or companies ) that are way too uncertain and instead pick stocks from the major indexes such as S&P 500.
Selling the SPX (or SPY) put option is also a good idea because what you are doing is essentially buying the S&P 500 if you get assigned. If you don’t trade options for living income you could just hold SPX and wait until it goes beyond your entry point to sell it for a profit.
Selling put options can be a profitable strategy for experienced investors and traders, but it’s important to understand the risks and manage them carefully. By identifying profitable trades, managing risk, and using technical analysis, you can take advantage of market volatility and generate income.
I would also recommend learning about the Wheel Strategy as it is a powerful strategy if you want to hold a stock for the long term.