Tag: investing

submitted by jwithrow.

Want to get paid up front to buy stocks you want to own at a price you specify? Selling put option contracts allows you to do just that.

Put options are a contractual agreement between two parties. The owner of the put option contract has the right to sell the designated stock to the counter-party at the agreed upon strike price at any time prior to the specified expiration date. In exchange for this right the owner of the put option must pay a market-based premium to the seller up front. Each contract is for 100 shares of the underlying stock.

For the owner, put options can serve two purposes – either as a downside hedge or as speculation. Generally speaking, the owner of the put option profits from the deal if the stock declines below the strike price.

In order to get paid up front to buy the stocks you want you simply need to “be the store” for hedgers and speculators and sell puts on stocks you would like to own. You choose the stock, the strike price, and the expiration date and you receive the premium immediately upon execution. That premium is yours to keep no matter what happens. If the stock is still above the strike price on expiration day then you walk away from the trade with pure profit. If the stock is below the strike price and the put option is exercised then you are obligated to buy 100 shares of the stock per option contract sold and the premium you were paid up front serves to reduce your cost basis in that position.

There are two basic strategies for selling put options. The first is to sell in-the-money puts on stocks you absolutely want to buy. This strategy can enable you to buy the stock at a lower price than it is trading for at the time.

Let’s use AUY as an example of this strategy (not a recommendation). AUY is currently trading at $4.48 per share. Instead of purchasing AUY at $4.48/share you could sell the February 20 5.5 Put for approximately $1.30 per share. This would obligate you to purchase 100 shares per put contract of AUY at $5.50 per share on or before February 20 and you would be paid $130 per contract up front to do so.

Now there are only two possible results. If AUY is trading above $5.50/share on February 20 then the put option expires worthless and you walk away with $130 per contract sold and you can explore selling more put options on AUY if you want. If AUY is still trading below $5.50/share on February 20 then you will be “put” the stock and you must purchase 100 shares per contract at $5.50/share. But you were already paid $1.30 per share so you would effectively be buying AUY at $4.20 per share ($5.50-1.30). Recall AUY was trading at $4.48 when you sold the put so you are buying the stock at a lower price than you could have originally.

The second strategy is to sell out-of-the-money puts on blue-chip stocks that you don’t think will dip below the strike price but you wouldn’t mind owning if they did. This is primarily a low-risk strategy for generating income and the lower premiums reflect this.

Let’s use WMT as an example of this strategy (not a recommendation). WMT is currently trading at $89.68 per share. We could sell the WMT March 20 82.5 Put for approximately $0.70 per share. In this example WMT would have to decline by roughly 8% in a little over two months for the put contract to be exercised. We walk away with $70 per contract unless that sharp decline happens.

As you can see, selling put options involves limited risk. You must keep enough cash in your brokerage account to purchase the underlying stock should the option be exercised but that is the most you can lose in each trade. If done properly, selling put options is actually less risky than buying stocks outright.

As always, be mindful of your asset allocation model before venturing into the equity markets.