How to Sell Put Options and Snag the Market’s Daily Deals
by Karim Rahemtulla, Investment U’s Options Expert
Tuesday, November 30, 2010: Issue #1397
Simple question: How do you invest?
Are you a straight stock buyer? Do you sell stocks short? What about options – do you mix in some covered call selling or LEAP-buying?
Over the past few weeks, I’ve run down the compelling benefits of another excellent options strategy, where you sell put options in order to buy the stocks you want at the price you choose and bank instant income in the process.
Many people are reluctant to employ put-selling in their trading, often because they simply misunderstand how to use the strategy most effectively, or they’re not using it properly at all.
Here’s how to do sell put options like a pro, ensuring that you get great stocks at great prices – and make money doing it, too…
How to Sell Put Options… and the Benefits of This Strategy
First of all, when you sell a put option, you:
- Obligate yourself to buy a particular stock at a predetermined price (the strike price).
- Receive money in your account immediately that is yours to keep, regardless of the outcome.
So let’s see how this works in reality with the following example…
~ Select Your Stock… and Make Sure You Like It: Having researched Dell (Nasdaq: DELL), you decide it’s a stock you’d like to own. (This is a crucial element in put-selling: Make sure the company is one you’d actually be fine with owning in case you’re obligated to buy the shares.)
~ Buy Lower: Dell shares are currently trading around $13.50, but instead of buying the stock outright today, you think you can buy it at a lower price in the future.
~ Pick Your Puts: The options chain for Dell shows the February 2011 $13 puts trading for $0.65. That means if you sell those puts, you’ll receive $65 for each contract you sell (there are 100 shares in each options contract). So if you sell 10 contracts (equivalent to 1,000 shares), you’ve:
- Received $650 in cash in your account.
- Obligated yourself to buy 1,000 shares of Dell at $13 per share.
- Reduced your cost in Dell to $12.35 if you end up buying the shares ($13 minus $0.65). But that only happens if – and only if – Dell closes below $13 at expiration. If the shares close above $13, then you only get to keep the original $650 premium that you received from selling the options.
So let’s run down the scenarios…
Your Options Expiration Scenarios
Once you’ve executed the put-sell trade, you just need to keep an eye on the movement of the shares, as you would do with any holding.
- If Dell Closes at $13 or Above by Options Expiration: This is the easiest scenario because in this case, you do nothing. The $650 you received is pure profit, with no further obligation. Your account will show confirmation that the put option has expired.
- If Dell Closes at $12 by Options Expiration: In this case, the stock has closed a full $1 below your strike price. It means the shares have been “put” to you.
However, if you no longer wish to own the shares, you can get yourself out of the position before options expiration. You simply buy the put options back at whatever price they’re trading for at the time – known as a “buy to close” transaction. For example…
- If Dell is trading at $12.10 the day before options expiration, the puts will be trading at $0.90 ($13 minus $12.10 – there’s no premium for time or risk since there’s only one day left.)
- In this case, you buy back the option for $0.90 per contract. Your loss is going to be $0.25 per share ($0.90 to buy back, minus the $0.65 received from the original put sell). You have no further obligation in the position.
On the other side of the coin, you might be happy that you’re getting Dell shares “put” to you at $13 – even though the price is now $12. Why?
Because you entered the trade for the right reasons. That is, you weren’t simply chasing as much cash as possible from selling put options, with little regard for the consequences. Instead, you “traded” Dell and bought it for the longer-term.
And here’s how that scenario works out…
You’ve Been “Put”… But What’s Your Actual Cost?
Remember, you sold the original Dell February 2011 $13 puts for $0.65. Assuming you’re okay with owning the stock, you must buy it for $13 per share (since it closed below $13).
For 10 contracts (worth 1,000 shares), that’s a total of $13,000. But your actual cost is $12,350 ($13,000 minus the $650 from selling the put options). If you sell Dell for $12 at this point, you’ll incur a $350 loss on the position.
Now that you own Dell, the trade is not over. Next time, I’ll show you how to extend the trade and put more money in your pocket.
About Karim Rahemtulla
With more than 20 years of experience, Karim has mastered the subtle art of options trading. What we admire about him is his ability to score huge gains while minimizing the massive amount of risk that often comes with options. Beyond his expertise in options trading, he is also the author of the best-selling book Where in the World Should I Invest? He publishes weekly about smart speculation in his latest free e-letter, Trade of the Day.