Being a net-seller of option premium is a proven way to generate returns. To answer the question of whether or not to sell puts to generate income, we need to understand what put options are.
Put options 101
A put option is a contract the gives the buyer the right to sell stock at a certain price within a defined time period. You’ve probably heard about this concept before. Put options are usually used to ‘ensure’ a stock owners risk of losses if the stock price falls in value.
So we’ve got the buyer side of put options down. What about the selling side?
When you sell a put option you are the one providing the above mention insurance to the buyer. Yep, that’s right – welcome to the insurance business. I’ll let you in on a secret: It’s a very good and profitable place to be.
Why? It is extremely difficult to price fear of the unknown, especially when human beings generally are really bad at understanding probabilities as well.
Consider options trading your way to become a small insurance company. And selling puts is a great strategy to start with.
What kind of risk is involved?
To understand the risk metrics of put options consider this example:
Stock XYZ is currently trading at $100. The put option with a strike price of $95 is being traded for just about $1. The expiration is just about 2 months away from today. From here on three different scenarios can happen in the time period: The stock price increases and ends up above $100, the stock price doesn’t move or the stock falls. The first two scenarios are obvious – you get to keep the premium from the put option you sold as it expires worthless. Let’s dig a bit deeper into the last scenario: The stock price declines.
First of all, because we sold an out-of-the-money put option with a strike price of $95 we still get to keep ALL the premium from the option as long as the stock stays above $95. That means that the stock can decline 5% while we still get the same positive return from our trading.
Now if the price of the stock declines further than $95 we are starting to, first of all, give up our premium of $1, and secondly incur losses. Because our premium was $1 our break-even is $94. This means that for every cent below $94 we are now in a losing position.
Those are the basics of selling put options. You are bullish to neutral on your chosen stock, and you allow yourself room to be wrong by selling an out-of-the-money put. In the imaginary example described above, we get a return on our capital of about 1.05% in the two months time. Do that 6 times a year and you’ll have a return of 6.32%. Not impressive compared to the historical and expected return of the stock market. If we are trading on
Let’s look at a real-life example of a trade. We’ll look at what it would be like to sell a put option on the ETF XLK (Select Sector SPDR Trust Technology) today (March 26, 2019). We are looking for an expiration of about 45 days, which brings us to
If we are selling cash-secured options we would have to put up an amount of money that equals the strike price times 100 (since every option contract controls 100 shares of stock) minus the premium received after costs.
In this case the this would mean: 70 x 100 – 96.85 = $6,903.15.
If XLK is above the $70 strike price at expiration our return will be 1.4%.
If we are trading in a margin account we would only have to put up $1,147.65 to make the trade. This means our potential return is 8.4%. Read more about trading on margin or not in an upcoming post.
What happens if the stock closes below our strike price? Well, first of all, we would hopefully have closed the position before that happens, but for the sake of argument let’s take a look at what would happen.
Scenario: XLK closes at $65
Since our strike price is $70 we would automatically be assigned 100 shares of the underlying asset (XLK in this case). Our loss would amount to the difference of the closing price of the underlying and the strike price of our put option multiplied by 100 plus the credit received from selling the put.
That is (65 – 70) x 100 + $96.85 = $403.15. There would usually also be assignment fees when getting assigned stock. At tastyworks, the assignment fee is $5.
If we instead of selling the OTM put had bought 100 shares of XLK or loss would amount to (65 – 73.20) x 100 = $820.
Selling puts is a way to go long a stock or ETF while still allowing yourself to be wrong in chosen your direction. It reduces your risk compared to buying stock out-right. At the same time, it provides you with a decent return on investment especially if utilizing a margin account.
But the questions
- Express an opinion on bullish direction an underlying
- Make money if you weren’t right
- Reduce risk compared to buying shares
Have you ever tried selling a put? What was the experience like? Love to hear your comments and thoughts.
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