Selling put options is a lucrative and highly effective income producing strategy
As the seller of a put option, you are agreeing to purchase shares of a company at a predetermined price (called the strike price) by a predetermined date (called the expiration date). Think of yourself as an insurance agent to the owner of the shares.
In exchange for this agreement, you (the seller of the option) receive an upfront payment from the owner of the shares. No matter what happens to the shares of the company, the payment is yours to keep.
The little known put selling strategy provides the following distinct benefits:
Predictable double digit income
High downside protection
Ability to purchase high quality stocks at discounts
Let’s take a look at some examples of selling put options
Coca-Cola (KO) currently trades at $45.03. At it’s current price, the dividend yield equates to 3.64%. Let’s say you like Coca-Cola and you would be happy to own shares of KO but would prefer to buy the shares at a lower price than they currently trade at. In the past year, KO has traded between $36.27-$60.13. Of course you could always put in a market order and buy shares of KO at their current price trading $15 lower than their 52 week high. Or you could put in a limit order at the price you want to pay and wait for it to reach your price (if it ever does).
But instead you could get the best of both worlds by agreeing to buy shares of Coca-Cola at a much lower price than it’s current price of $45.03 and get paid for doing so. So how would you do this? You guessed it – By selling a put option! Let’s look at the option table for KO.
Intimated? Don’t be. Above you will see an option chain for Coca-Cola (KO). Here are the key aspects of the option chain:
Expiration Date – On the left side you will see that this is the option chain expiring on September 18, 2020 (117 days remaining).
Strike Price – In the middle column you will see the numerous strike prices ranging from $20 to $45.
Bid/Ask – On the right side you will see the put option Bid/Ask prices for each strike price.
So where can you begin?
Let’s say you would be happy to purchase shares of KO at $38 – a discount of over 15% to current prices.
As seen by the Bid/Ask at the $38 strike price, someone is willing to pay you between $85-$90 to agree to purchase 100 shares from them at $38. If you agreed to sell them the put option for $87.50 (between the current Bid/Ask), you would immediately receive $87.50 in your account.
So what kind of returns could this give you?
Well, it depends on the amount of cash you keep as collateral once the trade as opened.
In the put selling world, there are two techniques:
1) Selling Cash Secured Puts – Selling a cash secured put means that, as the seller of the option, you are keeping the full amount to purchase the shares of the underlying stock at the predetermined strike price. In the Coca-Cola example, the seller of the put option would keep $3,800 as cash in their trading account just in case they needed to purchase 100 shares of KO at $38 a share. This is the most conservative way of selling put options and returns are significantly lower using this technique than selling naked puts. Selling cash secured puts can even be done in an IRA.
Example 1.
Through our put option selling calculator above, we see that selling the KO put option using the cash secured put technique would give us an annualized return of over 7%. Notice the cash requirement of $3,800. The “Breakeven Price” of $37.13 reflects the strike price ($38) minus the premium we will receive per share ($.875). As long as KO’s price stays above $37.13 (17.55% lower than the current price) between now and September 18th, 2020, this trade would be profitable. This would be the most conservative technique of selling a put option and therefore the returns are lowest.
2) Selling Naked Puts – Selling naked puts allows for significantly greater returns in comparison to selling cash secured puts. This is due to the fact that substantially less cash is required to be kept in your account while the trade is ongoing. Selling naked puts requires a margin trading account and as such, the full amount ($3,800 in the Coca-Cola example) is not needed to be kept as collateral. Instead, the broker will only require you to keep between 15%-25% of the total amount needed to purchase the shares at the agreed strike price. Using the Coca-Cola example, instead of needing $3,800 in your account for a cash secured put, you would only need to keep between $570-$950.
Example 2.
Through our put option selling calculator above, we see that selling the KO put option using the 25% naked put technique would greatly increase our annualized return to over 28%. Notice the cash requirement of only $950 in this example. Nothing changes from the cash secured put option except the Cash Required and as a result the Return/Annualized Return. This would be the riskiest technique of selling a put option and therefore the returns are highest.
Example 3.
Through our put option selling calculator above, we see that selling the KO put option using the 50% naked put technique would result in an annualized return of around 14%. Notice the cash requirement of $1,900 in this example. Nothing changes from the cash secured put option except the Cash Required and as a result the Return/Annualized Return. This is a good medium between selling a 25% naked put and a completely cash secured put. Returns are not maximized but the risk is substantially lower through the amount of cash kept as collateral. This is the only put selling technique we recommend to our subscribers and we have had great success with it.
You would be obligated to purchase the shares of KO from the option buyer at $38 between now and September 18th, 2020. If shares of KO remained above $38, the option would expire worthless and you could use your capital to sell your next put.
Let’s analyze the possible outcomes at expiration when selling puts
Just like any trading strategy, outcomes and exit strategies always need to be fully understood.
Outcome 1. The share price stays above the strike price you agreed to purchase the shares at. The option would then expire worthless and you would be able to use your income required and your cash you kept as collateral on your next trade. In the Coca-Cola example, if the price of KO shares on September 18th, 2020 were above $38 the option would expire worthless and you would make the rates of returns from the examples above depending on your choice of technique.
Outcome 2. The share price dips below the strike price you agreed to purchase the shares at. The buyer of the option would then have the right to sell you shares of KO at $38 a share. You still get to keep the premium you received from selling the option and therefore your actual cost per share would be $37.13 a share. You get to buy a great stock that you liked at over $45 for over a 17% discount.
Once you sell a put option, you can always exit the trade early (before the option expires).
Using the Coca-Cola example, you would have to wait 117 days until the option expired. Just like stocks, options are constantly bought and sold. As you can see based off of our Closed Trades we frequently close positions early by buying back the option that we sold for a lower price. So why would we do this?
The main reason is to maximize our annual returns. Let’s say that the KO option we sold at $87.50 is trading at $35 after a month. Instead of waiting another 87 days for the option to expire, we can buy back the option for just $35. Our returns wouldn’t be as high as they would if we waited for the option to expire after the full 117 days, but our annual returns would be greatly increased. We would be making $52.5 after a month ($87.50-$35). Therefore our annual returns would more than double since the duration of the trade was significantly shortened.
Understanding option pricing
Returns through selling put options can vary greatly depending on the underlying stock and its implied volatility. Coca-Cola is considered a blue chip dividend aristocrat stock and therefore volatility relative to most other stocks is low. For stocks that historically have low volatility, returns through selling puts are lower than average. Still, from the examples above you can see for yourself that returns from selling puts on Coca-Cola can greatly outperform the current dividend payment of only 3.64.%.
Returns for selling puts on stocks with high volatility can be very enticing but investors should only sell puts on high quality stocks that they wouldn’t mind owning. There are many opportunities to sell put options on high quality stocks without having to resort to risky low quality stocks that are not attractive investments.
From the simple graph above, you can see that as option sellers time is our best friend. As time passes, the value of the put option that we sell decreases meaning we become more and more profitable. At expiration, as long as the price of the stock is above the strike price we sold the option at, the value of the option will be zero.
Our specific strategy
Our newsletter/advisory focuses on creating income through selling put options on high quality stocks. Our goal is never to own the shares of the stock that we are selling puts on but rather capture the premium and close the option early or let it expire worthless overtime. So how do we find prime candidates for selling puts?
Insider Buying – Large purchases from insiders can signify undervaluation and possible future bullish price movement
Seasonality – Certain stocks have strong seasonal patterns that repeat themselves year after year
Overreaction – High quality stocks are oftentimes impacted by overall market dips although they’re business or fundamentals do not change
After finding an ideal stock for selling a put option we must analyze the option chains in order to increase our chances of success and maximize returns. Here are a few things we analyze regarding the option chains:
Liquidity – Some stocks have very low option liquidity and the bid/ask prices for the put options specifically can have a very large spread. Put options we recommend selling must have high liquidity which allows our subscribers to actually enter/exit the trade at the prices we recommend. There must be a significant supply and demand for all options we recommend.
Downside Protection – Also known as percent “out the money” meaning how far the stock price would have to dip before we would be assigned shares of the stock. We obviously want the protection to the downside as high as possible when entering the trade although it will vary greatly depending on the market and stock volatility
Annual Return if Held to Expiration – We are always aiming to achieve annual returns of at least 12% if we were to hold the put option to expiration. You will see from our closed trades that we usually achieve a much higher rate of return due to closing the position early. As time passes and the put option value decreases we can close early and increase our annualized return percentage.