Selling Puts For Income
By Stock Options Channel Staff
If you understand the concept of placing a good-til-canceled limit order to buy a stock, then you are halfway to understanding selling put options. This article will explain further.
Since 2003, our company has operated the stock picking discussion community ValueForumTM, where members gather each year for an event we call InvestFestTM. Both online and at these events, stock options are consistently a topic of interest, and a key strategy discussed is selling puts.
The best way we've found to explain the concept of selling put options to someone learning about them for the first time, is to start with the notion of a stock you are interested in buying. Suppose that stock is trading somewhat higher than the price you want to pay. Perhaps you might normally think about placing a good-til-canceled buy order for that stock, at a limit price somewhat lower than where the stock is trading.
You might change your mind a few days later and cancel the order, but oftentimes that good-til-canceled order to buy the stock would be left to either fill or expire at the date you designated. Imagine, however, that you were so sure of the buy order that you would be willing to commit to leave it open for a month, maybe two months, maybe three, maybe even a whole year? There are other market participants out there who are willing to pay you to make that commitment, to them. In options jargon that payment is known as the "premium" and when you make the commitment you enter into a "contract" essentially giving that other person the option to fill your buy order.
Entering into such a commitment for a specified period of time, to buy a certain amount of stock, at a certain price, is essentially what "selling a put" means. You are entering into a commitment — a contract — and getting paid for doing that. In options jargon, the pricepoint at which you commit to buy the stock is known as the "strike price."
Everything is standardized and organized in the options market, so for example you couldn't specify 258 shares at a price of 10.01 and a date of next Tuesday, the way you could with a limit order to buy. You would only be able to use 100 share increments and only be able to choose from among the pre-specified expiration dates and strike prices available. Typically there are available strike prices at every 1.00 increment or 2.50 increment, etc. all depending on the particular stock. There are typically at least four different months out into the future to choose from, and sometimes longer-term choices of a year or more as well.
All of this structure and organization delivers a very big advantage: all of the options contracts are standardized. Let's examine what happens if you "sell to open" a put contract ("sell" because someone else is paying for your commitment so they are the buyer and you are the seller, and "open" because you are entering into — opening — an agreement, a contract with that buyer). Suppose the strike price is 10.00, the expiration month is three months away, and you committed to buy 100 shares (equal to 1 contract, because the standard in the options market is for each contract to represent 100 shares, the minimum increment). If your friend does the same exact thing, your two contracts are no different from one another, and in fact no different from the contracts created by any other market participant who picked that same strike price and that expiration month. The total of all existing contracts at a given strike price and expiration month is known as the "open interest" for that put contract.
That brings us to the benefit, the advantage of all this standardization and organization. Market participants can pair up with anyone in the world, without even knowing who is on the other side of the trade or whether they are opening or closing their position — you are blind to all of this, just the same way you don't know anything about who is on the other side of the trade when you buy or sell a stock. This creates the framework for a high volume marketplace and means the interested parties don't have to work to seek each other out, because anybody with the right kind of brokerage account can participate.
This means, for example, that if you change your mind a few days later, you can "buy to close" the put options you sold, and you might actually be buying those contracts from a different person than the one you sold to originally. Going back to the example from the beginning of this article, that would accomplish the same thing as canceling your limit order to buy, in other words your commitment to buy the stock has been crossed out.
Who out there is willing to pay me for doing this, you might ask? Because strike prices are sometimes very far away from the current market price of the stock, it can initially be confusing to think about the reasons someone would utilize the options market, versus just trading shares of the stock directly. But there are lots of different reasons someone might want to buy a put option from you even at a price beneath where the stock presently trades, just as there are many reasons motivating both the buying and selling of a share of stock.
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Since 2003, our company has operated the stock picking discussion community ValueForumTM, where members gather each year for an event we call InvestFestTM. Both online and at these events, stock options are consistently a topic of interest. The two most consistently discussed strategies are: (1) Selling covered calls for extra income, and (2) Selling puts for extra income.
The Stock Options Channel website, and our proprietary YieldBoost formula, was designed with these two strategies in mind. Each week we put out a free newsletter sharing the results of our YieldBoost rankings, and throughout each day we share even more detailed reports to subscribers to our premium service.
On the CALLS side of the options chain, the YieldBoost formula looks for the highest premiums a call seller can receive (expressed in terms of the extra yield against the current share price — the boost — delivered by the option premium), with strikes that are out-of-the-money with low odds of the stock being called away.
On the PUTS side of the options chain, the YieldBoost formula considers that the option seller makes a commitment to put up a certain amount of cash to buy the stock at a given strike, and looks for the highest premiums a put seller can receive (expressed in terms of the extra yield against the cash commitment — the boost — delivered by the option premium), with strikes that are out-of-the-money with low odds of the stock being put to the option seller.
The results of these rankings are meant to express the top most ''interesting'' options identified by the formula, which are meant as a research tool for users to generate ideas that merit further research.
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