Selling Put Options – Getting Paid To Wait And Buy Stocks For Less

How would you like to buy a stock for less than it is currently trading?

By selling put options, you can do just that and get paid to wait for a pullback.

So what’s the catch?

Today we’ll answer that question and more.

We’ll look at various strategies for selling put options as well as some detailed examples to help you understand the entire process.

Introduction

Selling puts is a great strategy for beginners start learning options trading.

When you sell a put option, you’re selling someone the right (but not the obligation) to sell you 100 shares of the underlying security at a certain price (strike price) before a certain date (expiration date).

For selling this right to the buyer, the put seller will receive a premium from the buyer.

That premium is the sellers to keep no matter what happens, but they are now on the hook to buy the shares at the strike price if called upon to do so.

Benefits Of Selling Put Options

Selling put options is essentially an income strategy. It is very similar to covered call trading with similar risks, rewards and profit potential.

By selling puts and investor can:

  • Achieve above-average returns while waiting for the stock to come down to a price at which they are happy to buy.
  • Gain some downside protection if the stock drops. A 20% drop in a stock may see the put seller suffer only a 10% loss due to the premium received.
  • Make effective use of spare cash while waiting to get in to the market.
  • Take advantage of high volatility during market corrections. Taking a contrarian approach when there is a lot of fear in the market can see put sellers handsomely rewarded.

Like any option strategy, there are times when selling puts will perform well and times it will underperform.

Selling puts works great in sideways, slightly bullish and even slightly bearish markets.

However, this strategy will underperform during raging bull markets as investors will miss out on the capital gains provided by rapidly rising stock prices.

The Mechanics Of Selling Puts

It’s always easiest to learn through examples, so let’s take a look at the how selling put options works. We’ll work through a theoretical example first to help you grasp the concept before moving on to real examples.

Let’s assume ABC Corporation is trading at $100 and you are happy to buy it in one months’ time for $95.

You, therefore, sell a 1-month, $95 put.

For selling this put, you receive $3 in premium which is $300 in total.

You also have the obligation to buy 100 shares at $95 if called upon to do so which would cost $9,500.

If assigned, your net cost to purchase the shares would be $9,200 due to the $300 premium received.

Here’s how things might work out:

SCENARIO ONE – STOCK STAYS ABOVE THE STRIKE PRICE AT EXPIRATION

In this case, your put expires worthless and the obligation from selling the put is removed from your account.

Your capital is now freed up to make a new trade.

The rate of return would be:

$300 / $9,200 = 3.26%

That’s a pretty handy return for sitting around and waiting for a month.

SCENARIO TWO – STOCK DECLINES BELOW THE STRIKE PRICE AT EXPIRATION

In this scenario, the put buyer is likely to exercise his right to sell the stock at the strike price given he can rebuy in the market at a lower price if he still wants to hold the stock.

You now own 100 shares with a cost basis of $9,200 and hopefully, the stock hasn’t declined too much below $92.

Still, you now own shares at $92 in a company that you liked when it was trading at $100.

What To Look For When Selling Puts

The most important thing to look for is strong companies.

Selling puts is a proxy for buying shares in a company so only look at strong companies that are highly rated.

You want to try and reduce the risk of adverse price moves in a company’s stock, so sticking to solid companies is rule number one.

I like to use Investor’s Business Daily to check out a company before selling a put because they have an excellent rating system, so this is a great sanity check to make sure it’s a strong, highly rated company.

From a technical analysis standpoint, I like to look for stocks that are above their 20, 50 and 200-day moving averages.

This is just another indication that it is a strong stock in an uptrend.

Using these moving averages as stop-loss levels can also be a good idea if the stock starts to head south.

Another factor to consider is a company that displays a sold dividend history.

This can be advantageous because if you do get assigned on the shares, you want to receive extra compensation for holding the shares.

Shares in the Dividend Aristocrats and Dividend Kinds list are good places to start as is the Dogs of the Dow.

Checklist For Selling Puts

When trading, it’s always good to have a plan rather than flying by the seat of your pants.

Below you will find some key criteria to consider before selling puts options on a company.

You may choose to use some or all of these, but you should definitely have a similar checklist and full trading plan before getting started.

1. Am I bullish on the stock?

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Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are ...

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