Are You Making This Huge Trading Mistake?
Today, I want to show you the right way to sell put options.
Whether you’re an investment veteran or just opening your first brokerage account, I urge you to listen. Chances are you need to hear this message.
#-ad_banner-#Regular readers of StreetAuthority likely know that a put option is a security that gives the buyer the right — but not the obligation — to sell a stock for a certain price in the future. In return for opening the trade, the seller receives an upfront cash payment known as a premium.
Done correctly, selling puts is one of the best investment strategies available. It’s a great way to collect thousands of dollars in additional monthly income. The problem is that many investors sell puts the wrong way.
When most options sellers approach a trade, they engage in something I like to call “premium chasing.” That is, they only look for trades that offer the highest premiums. They’ll sell puts on things like gold miners, tech startups or boom-and-bust companies. Because these stocks are volatile, they tend to offer higher payouts.
This is without a doubt the biggest mistake an options seller can make. Selling options on high-risk stocks just because they offer high premiums is a lose-lose situation. Even if the trade works in your favor, you’re simply accepting too much risk for the amount of return you’re generating.
Take the well-known stock First Solar (NASDAQ: FSLR), for example.
Shares of FSLR are currently trading around $46.75 a share, and the January 45 puts are trading at $2.20. Since each put contract controls 100 shares, a trader would receive $220 in premium for selling one FSLR Jan 45 Put. Because the trade requires $1,000 in margin to open — most brokers require a minimum down payment of 20% — it offers a return of 22% in just over six weeks. It’s numbers like this that entice people to play this game.
The problem is that by opening this trade, the trader is now completely exposed to the stock’s downside. If First Solar closes below $45 when the option expires, he or she will have no choice but to buy 100 shares for $45 apiece, regardless of where it’s trading on that day. FSLR has traded in a range from $45 to $75 in the past year. And with a beta of 3.15, it is theoretically 300% more volatile than the market. There’s just no telling where its price will be six weeks from now.
Meanwhile, the most a trader can make from selling the put is $220 — and that’s the best-case scenario. If FSLR closes a penny below the $42.80 cost basis ($45 strike price minus $2.20 they received for selling the put) the day the option expires, they’ll be in the red. That’s not unlikely considering FSLR’s price action.
In essence, the trader is exposed to unlimited downside simply to chase a 22% return.
This is why so many people lose money selling options. They’re too focused on the premium and not enough on the risk to make a good trade. So when they’re suddenly blindsided by a downswing in the market, they start racking up huge losses.
But I’m not trying to scare you away from selling puts. It’s a great strategy — you just have to know how to do it.
The secret to a successful put selling strategy is to only sell puts on stocks that you want to own. Stocks you would have no problem buying if they fell 10% to 20% in price. Stocks like Microsoft (NASDAQ: MSFT), for example.
Microsoft controls roughly 50% of the market share for operating systems, brings in $91 billion in revenue annually and has raised its dividend in eight of the past nine years.
Better yet, as one of the most widely held stocks in U.S. 401(k) accounts, Microsoft is also among the most popular stocks in America. Chances are you personally own shares of MSFT through your IRA.
With that kind of market interest, Microsoft has natural price buoyancy. Mutual funds, investment managers and conservative income investors alike flock to it when it pulls back.
Bottom line: A crash in Microsoft is a lot less likely than a crash in a stock like First Solar.
Of course, that’s not to say companies like First Solar are bad investments. FSLR was one of the best-performing companies in 2013, returning 77% versus 30% in the broader market.
The problem is that stocks like these aren’t good put selling candidates because, as I showed you earlier, selling options on them only gives you a small piece of the upside while exposing you to all of the potential downside.
That’s why when it comes to selling puts, it’s much better to use “boring” companies like Microsoft. Their steady price movements mean that if there is a sell-off, you simply end up buying a great stock at an ever better price.
Unfortunately, traders looking to hit home runs overlook companies like Microsoft. Since it usually stays within in a predictable trading range, the options premiums are generally too low to catch their eye.
But that’s a mistake. While the payouts might not triple-digit annualized gains, Microsoft can still generate 10% to 15% a year as part of a conservative put selling strategy. That’s a lot of upside considering the risk you’re taking. And those are exactly the kinds of odds that make for an ideal trade.
Using this options selling approach is exactly what’s led Amber Hestla to a perfect track record in her premium service, Income Trader. By only selling puts on undervalued stocks she wouldn’t mind owning, Amber has helped readers secure an average annualized gain of 54.5% . Better yet, not a single one of her closed trades has lost money. To see Amber’s track record, or to simply learn more about selling put options, follow this link.
This article was originally published on ProfitableTrading.com: Are You Making This Huge Trading Mistake?