In today's market, it has become difficult for investors to generate income. Interest rates are at historically low levels, bond portfolios feature high prices and low yields, and it has become hard to find dividend stocks that have generous payments without significant risk.
Over the past few months, we have written at length about the covered call method, which allows us to sell call options against individual stock positions and collect extra income from selling these contracts. Today, we want to introduce you to another income-generating options strategy that involves selling put options against a stock that we would like to own.
They say a picture is worth a thousand words. When explaining a financial transaction, sometimes a real-life example is just as valuable. So to illustrate how the put selling strategy works, I'm going to use a real example that is not directly tied to the stock market.
A Collector's Story
Let's say you have a friend who is a collector of high-end cars. Whether it's a 1950s American muscle car or a limited edition Italian sports car, he has an interest.
In fact, more than just a hobby, his obsession with collectible cars is a full-fledged family business.
Whenever your friend has his eye on a car, he takes an unusual approach to purchasing it. Instead of making a direct offer to buy the car from the dealer, he adds a little finesse to his strategy. Since this is a business and not just a hobby, he must buy all of his cars at an attractive price. If he pays too much, he's likely to get saddled with an investment he can't sell -- at least not for what he paid for it.
So instead of buying a car for its Blue Book listed price, your friend strikes a deal with the owner. He lays out a price below the current market value, and says that he is willing to buy the car for that price anytime over the next six months.
So for instance, if a collectible car has an expected value of $60,000, he will offer the owner $55,000 anytime between now and the end of the year. Most car dealers like this offer because if they have made a mistake in their calculations, or if they simply can't find a buyer, they know that your friend will at least take the car off their hands for a small loss. (It can be very expensive for car dealers to keep inventory that is not selling).
There is one catch with this strategy, however. Instead of making this offer outright, your savy friend requires the dealership to pay him $1,000 to keep the offer open. This way, if he doesn't get to purchase the car at a discount, he still makes a little bit of money on the side. And if he does purchase the car, well, that's what he wanted in the first place, right?
Your friend does not wind up purchasing most of the cars that he makes an offer on. Usually, the dealer is able to sell the car for a higher price, and your friend simply cashes his $1,000 check. But occasionally, he ends up with a car that he can park in his garage, tinker with, and eventually sell for a profit.
Tying it Back to Selling Put Options
This strategy is essentially the same concept that we use in a put selling strategy.
To sell a put option means that we are giving someone else the right but not the obligation to sell stock to us at a predetermined level. This means that we are taking on an obligation to buy that stock if the owner of the put contract elects to exercise their right. It also means that we are being paid for taking on that obligation -- and this is a good way to earn extra income in your investment account.
For the most part, we like to use the put selling strategy on stocks that we really want to own that have been beaten down. Like your friend, when we sell a put contract, we are making an offer that is below the current market price for a specified amount of time, and expect that the majority of the time we will not actually be obligated to purchase stock. Instead, we'll just collect the premium from selling the puts -- which in turn boosts the value of our investment account.
However, there are times when we will be obligated to buy shares of stock. This is why we prefer to use stocks that we ultimately want to own, and stocks that have already been beaten down. Selling puts on these types of stocks ensures that it will be in an attractive stock that is trading at a significant discount to historical prices.
One thing to make sure of when you employ this strategy is that you have enough capital to cover any potential stock acquisitions. This is important to remember because if you are too aggressive and sell too many put contracts, you could wind up with an obligation that you do not have the capital to fulfill. For example, when selling put contracts, remember that each contract represents 100 shares. So if you are selling a put contract with a strike price of $20, you need to have $2,000 available in your account in case you are obligated to purchase 100 shares at $20.
As you gain experience selling these contracts, your account balance should grow steadily. A higher balance allows you to increase the number of contracts you can sell, resulting in an ever-growing (compounding) income stream.
(This article originally appeared on ProfitableTrading.com.)