What are put options?
Put options are a type of financial contract that gives the holder the right, but not the obligation, to sell an underlying asset at a predetermined price (known as the strike price) on or before a specific date in the future. In simpler terms, it’s like buying insurance for your stocks – you have the option to sell them at a set price if they drop below that price.
How do put options work?
Let’s consider an example. Suppose you own 100 shares of XYZ Company, currently trading at $50 per share.
However, you’re concerned the price might fall in the next month. So, you decide to buy a put option with a strike price of $45 that expires in a month.
This put option gives you the right to sell your shares for $45 each even if the market price falls below this level.
Now, imagine XYZ Company’s price drops to $40 per share. Because you have the put option, you’re still able to sell your shares for $45 each, thus avoiding a larger loss.
This is the basic principle of putting options: they provide a safety net against potential losses.
How to sell puts?
Selling put options, also known as writing put options, is an ideal strategy for generating recurring income.
When you sell a put option, you collect a premium upfront from the buyer. This premium is yours to keep, no matter what happens in the future. Consider it as income earned for undertaking the obligation to buy the underlying asset at the strike price, should the buyer decide to exercise the option.
Here’s how to do it:
- Identify a stock you’re interested in buying. The first step in selling put options is to find a stock that you wouldn’t mind owning if its price dropped. This is crucial because if the stock price falls below the strike price, you will be obligated to buy the shares.
- Determine the strike price and expiration date. The strike price is the price at which you’re willing to buy the shares if the option is exercised. You also need to select an expiration date for the option – this is the date when the contract ends.
- Sell the put option. When you sell the put, you are paid the premium by the buyer. This premium is your income and is yours to keep, whether or not the option is exercised by the buyer.
By selling put options, you can create a stream of income while potentially buying stocks you like at a price lower than the current market price.
However, this strategy comes with its risks. If the stock price falls significantly below the strike price, you will be obligated to buy the shares at the strike price, which can lead to significant losses.
Selling put is also known as the first step in executing the Wheel Strategy.
Selling Covered Put vs Naked Put
The covered put strategy is typically employed when an investor has a short position in a stock and sells a put option on the same stock.
The ‘covered’ aspect refers to the fact that the investor’s risk is somewhat covered by the short position in the stock. This strategy is used when the investor expects the stock price to decrease.
- Covered Put Example: Let’s consider a real-world example: Suppose you’ve short-sold 100 shares of XYZ company at $50 per share, expecting that the share price will decrease. To protect your position and generate premium income, you decide to sell a put option (1 contract = 100 shares) with a strike price of $45 and an expiration period of one month. The buyer of the put option pays you a premium of $2 per share ($200 for the contract).
- Outcome: If the price of XYZ company’s stock drops as you anticipated, the put option will be exercised by the buyer, which means you will have to purchase the stock at $45, and still keep the premium of $200. Your short position in the stock will yield a profit from the decrease in the stock price and offset the further decrease in the stock price from $45 (it’s covered).
As you can see, a covered put almost mimics a covered call strategy except you’re betting on a slight downturn in the security’s price to make a profit.
On the other hand, a naked put is
On the other hand, a naked put is also typically known as cash secured put. It involves selling a put option without having any existing short position in the underlying stock.
The total risk is equivalent to the total amount of the stock price if the stock price decreases to zero.
Risk of selling put options
The main risk is the potential for significant losses if the stock price decreases dramatically. If the stock falls below the strike price, you will have to buy the shares at that price, potentially leading to a loss on your investment.
Other risks to consider:
- Liquidity Risk: In the event that you need to exit your position, there is a risk that the market for the option you sold may become illiquid. This could potentially result in losses as you may have to sell at unfavorable prices.
- Early Assignment Risk: While it is generally a rare occurrence, there is a risk that the buyer of the put option may decide to exercise the option before its expiration date.
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 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 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 strongly recommend learning about technical analysis if you have not done so.
Selling puts for income
One of the most commonly asked questions when it comes to trading options for income is whether selling put options could be a viable strategy.
The answer is yes, but it’s important to understand the potential risks and rewards.
By selling put options, you are essentially agreeing to buy a stock at a predetermined price (the strike price) if it falls below that level by the option’s expiration date. In exchange, you receive a premium from the buyer of the option.
This strategy can be profitable as long as the stock price remains above the strike price, you keep the premium and do not have to buy any shares.
It’s also beneficial to know selling puts is a part of a popular strategy among options traders called “wheel strategy,” also known as the “triple income strategy.”
It’s a cyclical process that starts with selling a put. If the option is exercised and the trader ends up owning the stock, they then sell a covered call option on that stock, again earning a premium. If the call option is exercised, they sell the stock at a profit. The cycle repeats from there, hence the name “wheel strategy.”
The wheel strategy is favored due to its potential to generate income in three ways: through the initial premium from the put, the second premium from the call, and potential capital gains from selling the stock.
Best Stocks to Sell Put Options
If you are a beginner at trading options, I would recommend selecting stocks that you do not mind owning by selling put options. Avoid picking stocks (or companies ) that are way too uncertain and instead pick stocks from the major indexes such as the 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.