Put Option Selling: Get Paid to Buy the Stocks You Want
by Lee Lowell, Guest Contributor, Investment U
Thursday, November 6, 2008: Issue #882
Did you know that you could get paid to buy stocks at the price you want? That’s right, someone will actually hand you cash today for your promise to buy any stock you want at a cheaper price than where it’s currently trading.
All you have to do is decide which stock you want to buy, at what price you want to buy it, place the trade and collect your money.
Is this for real? Is this a joke? Is this legit?
This is absolutely for real, it’s absolutely not a joke and it is extremely legitimate. When was the last time someone gave you a wad of cash just for buying your favorite stock at rock-bottom prices? I’m guessing probably never, unless you’ve been using this very simple and safe strategy. I personally use it all the time, and many others “in the know” have been using as well.
Being a professional options trader for the last 17 years, I’ve figured out exactly which options strategies are best to use at various times in different market environments. But one strategy can be used at almost any time…
It’s called “put option selling” and it’s a great way to get your hands on instant cash while at the same time giving yourself an opportunity to buy your favorite stock at a price much lower than where it’s currently trading.
Many people have never heard of, let alone used, this option strategy, but in my book there’s no better way to spend your time and effort while you wait for your stock to come down in price. I’m going to show you how you can use it to start collecting some of that cash that’s being handed out.
Being Paid to Wait With Put Option Selling
What do you usually do when there’s a stock you want to buy but it’s too expensive? I’ll bet in most cases, you enter into a limit-buy order for that stock using a price that’s lower than where it’s trading.
That’s how 95% of investors do it, so don’t feel bad.
But what are you doing in the meantime, while you’re waiting for the stock to drop in price? I’ll bet you’re just sitting there twiddling your thumbs and wasting valuable time. Has anyone given you cold, hard cash while you sit there and wait? Nope. Could you be doing something better with your time while you wait? Definitely.
Well, then put option selling might be right for you.
The actual mechanics of put option selling is quite easy:
- When you enter into a put-sell transaction, you’re entering into an obligation to buy the stock you want at the price you want.
- The person on the other side of the transaction, the put option buyer, pays you money today for your obligation to buy that stock sometime in the future at your price.
Put option selling is a bullish option trading strategy while put option buying is a bearish strategy.
When someone thinks a stock is going to fall in price, they can either short the stock or buy a put option contract. If they opt to buy the put option contract, they have to pay for it at the going rate.
That’s where you, the put option seller, comes in. Since you’re bullish, you want to sell that put option and the option buyer will gladly pay you the going rate for it. You keep that money, deposit it into your account and wait for option expiration to come. Easy enough, but let’s go over some specifics.
Options Trade As Easily As Stocks
Options contracts trade in the marketplace just as easily as stocks do. All options have “strike prices.” These are the levels in which you can buy or sell the stock if called upon to do so.
For example, IBM is trading at $90 currently. The options exchanges set up strike prices at various levels, like the $80, $90, $100, $120, $150, etc. You will buy or sell these strike prices at the going rate for each. An option like this, with say five months before expiration, could cost roughly $750.
All options have an expiration date that can span from days to years. When someone buys a put option whose strike price is set lower than the current price of the stock, it’s called an “out-of-the-money” put option.
Option contracts represent 100 shares of stock, so for every option you sell, you’re obligating yourself to potentially buy 100 shares of stock.
If someone chooses to buy the “$80 put option” today when IBM is at $90, they are speculating that IBM will fall below $80 per share by option expiration date.
Why would anyone want to sell IBM at $80 when it’s currently trading $90? Why don’t they just sell it now at $90? Good question. Probably because this person already owns IBM shares in their account and wants protection in case of a disaster.
If IBM happens to fall to $60 per share before expiration, the put option buyer can “exercise” the option and sell IBM at $80 even though it’s now trading at $60. This is how professionals “hedge their position.”
But what happens if IBM never falls to $80 by expiration? Well, the option expires worthless and the put buyer ends up losing the full $750. Who gets to keep that money? You, the option seller! It’s been estimated that up to 90% of out-of-the-money options will expire worthless, so in most cases, you’ll get to keep the money free and clear.
How to Buy Stocks for Less With Put Option Selling
Let’s say that you want to own IBM at $80 per share while it’s trading at $90. Instead of putting in that limit-buy order and waiting, you now know that you could sell the $80 put option and collect $750 for every option that you sell.
If IBM happens to end up trading below $80 per share at option expiration, then you’ll be called upon to buy your shares at $80 per share. That’s a good thing because $80 was the price you wanted to acquire it, and $10 cheaper than where it had been trading. Not only that, but someone paid you $750 extra per option just for your time and effort to buy your stock at your price.
Since options trade in 100 multiples, the option is quoted as $7.50. When it’s time to collect the money, you will receive $750 (100 shares x $7.50).
Even better, that $7.50 actually lowers your cost basis if you have to buy the stock. Even though you’re buying IBM at $80 per share, it’s really only costing you $72.50 per share when you factor in the $7.50 you received up front – an extra bonus.
Here’s a sample option chain for IBM options that expire in April 2009. The option chain lists all options activity and the options that trade for a particular stock and can be accessed online or from your broker.
You can see with IBM currently at $88.22 per share, the April 2009 $80 put option can be sold for $7.50 (splitting the bid/ask prices). So for every option you sell, you will instantly collect $750. If you sold 5 put options, you would receive $3750.
Put Option Selling & Option Expiration Day 2009
Here’s what goes down at option expiration day in April 2009:
- If IBM is trading above $80 at expiration, then the options will expire worthless and you get to keep the full $750, no questions asked. You can then move on and do another put-sell trade for a future expiration period. Unfortunately, you will not be asked to buy any shares at $80. But at least you were compensated $750 per option for your time.
- If IBM is trading below $80 at expiration, then congratulations, you will be called upon to buy the shares at $80 a piece. This is good news because $80 was the price you wanted to acquire them. Plus, you still get to keep the $750 paid to you on Day 1. The shares will show up in your account and you’ll be required to pay for the shares in full at that time. If you sold five option contracts, which is the same as 500 shares of stock, you will be required to pay out $40,000 at that time.
Just remember, you’ll only get to buy the shares if the price of the stock is trading below the strike price on expiration day
A few points to consider before implementing a put-selling plan of attack:
- Only sell put option contracts on stocks that you want to own for the long haul, as you might be required to buy them at expiration. We use this strategy to acquire high-quality, top-notch stocks. Don’t sell put options on risky stocks that you have no intention of buying, or only do it just to receive the put option income.
- You will need to have an option trading account set up with your broker in order to sell put options.
- Only sell the amount of put options that correspond to your buy levels. If you eventually want to buy 500 shares, then don’t sell more than five option contracts.
- You will need to keep a percentage of money in your account on hold at all times while the trade is active. This percentage is called the “margin requirement” and is set by your broker. In most cases, your broker will ask you to keep anywhere from 10% to 50% of the full purchase price of the stock while the trade is active. This is great, as you don’t need to keep the full $40,000 (in the IBM example) on hold at all times. This still allows you to use your funds for other trades
That’s it, put selling, in a nutshell. It’s an alternative way to acquire stocks while getting paid for your time and effort. You get to pick the stock you want and the price at which you’re comfortable owning it.
Just remember, stick with quality stocks that you want to keep for the long haul.
Today’s Investment U Crib Sheet
Options can be confusing at first, but with familiarity, they become just another tool in your investment toolkit. Here’s a quick review of some of the key put option topics.
- Options Chain – listing of a stock’s option contracts of puts and calls. An options chain is broken down by strike price and expiration date, with each option receiving its own security symbol.
- Strike Price – the price at which a contract can be exercised.
- In the Money – if a put contract is lower than the strike price, the contract is considered in the money. It means that the contract will make money for its owner.
- Out of the Money – if a put contract is higher than the strike price, it is out of the money. The price is too high for the transaction to be profitable – it makes no sense for the owner to exercise the contract.
- Expiration Date – date at which the option is either exercised by, or expires worthless.
- Time Decay – while not discussed much, the value of an option contract is based on several things, one of them being time value of the option. The longer an option has control over a stock, the pricier it is. Time decay is the declining value of an options contract as it approaches its expiration date.