Selling put options in your investment account is a great way to create a healthy level of income.
The process is fairly simple. We start by selling a put option contract for a stock that we would like to own. This contract obligates us to buy 100 shares of the stock if the stock closes below a certain price, called the strike price, on the date when the put contract expires.
From our perspective, this is a win-win situation. You either create income in your account with no obligation, or are obligated to buy a stock you already wanted to own at a cheaper price.
But even with this simple strategy, there are still some details that must be nailed down. After all, we want to make sure we are generating the maximum amount of income with the least amount of risk.
One of the biggest questions for traders who use this strategy is: Which put contract is best to sell?
More specifically, put traders need to select the contract with the right strike price for their particular situation.
In the Money or Out of the Money?
When evaluating put contracts to sell for income, we can break the available choices into two primary categories:
1. In-the-money put contracts have a strike price above the current stock price. They are considered "in the money" because the puts will be "exercised" and we will be obligated to buy shares if the stock remains at this level through expiration.
2. Out-of-the-money put contracts have a strike price below the current stock price. These contracts are considered "out of the money" because the puts will not be exercised, and will instead expire worthless if the stock remains at this level through expiration. If the puts remain out of the money, we will not be obligated to buy shares.
The question of whether to sell in-the-money puts or out-of-the-money puts depends heavily on what your expectations are for the overall market and the underlying stock.
As a general rule, we like to sell out-of-the-money puts during turbulent periods or when stocks are trading at an extended level. These puts have a lower nominal price because the obligation is less likely to be exercised (so they carry less value for the buyer). Selling these puts creates less income in our account due to the lower amount of premium we collect.
But even though this approach creates less income, it also carries less risk for us as sellers. Remember, the stock needs to trade lower if we are to be obligated to buy shares. So selling out-of-the-money puts automatically builds in a margin of safety for our position. Depending on how far out of the money the put contracts are, the stock could drop a relatively substantial amount without our obligation to buy kicking in.
Bringing It All Together
Given the uncertainty in today's market, you may be more interested in selling puts that are out of the money. Many of the stocks that you might like to own right now might be fairly extended and vulnerable to pulling back. And from a macro perspective, there are still a number of risks that could send equity indices lower.
On the other hand, during strong bull market periods where investors can generally expect stocks to continue trading higher. So if you think this bull market can continue, then selling in-the-money puts can be a bit more lucrative.
In-the-money puts typically trade with higher premiums because they already represent significant value for buyers who would purchase the put contracts. This is because the stock price is below the strike price, so the owner of a put contract has the right to sell us the stock above the current market price.
If we sell in-the-money puts, which carry a high nominal price, and the stock trades higher than the strike price before expiration, we will be able to keep the entire amount of premium we received for selling the puts, and we will not be obligated to buy any shares of stock. In this instance, the further in the money our contract is, the more cash we get to collect.
But if the stock does not trade above the strike price before the puts expire, we will be obligated to buy the stock at the higher strike price. But keep in mind that this was a stock we already wanted to own. And given that we sell in-the-money puts in strong bull market environments, as a general rule, we can expect the trend to continue, giving us a healthy investment that has a high probability of achieving more gains.
So the question of which put contract to sell depends largely on the overall market environment and our expectation for the underlying stock.