An Introduction to Making Money by Selling Put Options
If you were offered cash right now for the chance to buy your favorite stock later at a cheaper price, would you take it? If that sounds like a good idea, you might be cut out for selling put options. Because that right there is selling put options in a nutshell.
If there’s a stock out there that you know you want to invest in, but it’s trading just a little higher than you’re willing to pay, consider selling puts. It’s a fairly straightforward way to make money off a trade you’d be making in the future anyway.
Selling put options can be a quick way to pull in capital you can put to work right away while waiting for a stock’s price to drop. This falls into the passive income category… It’s a way to make money while remaining on the sidelines of the stock market.
On the surface, it might sound too good to be true. But it’s not. People will give you money in exchange for the prospect of buying a stock at a lower price than it’s currently trading for. And the best part is that this strategy can work no matter the market conditions.
Selling put options has been around since the 1970s. But it’s still not a terribly well-known (or well-understood) strategy. If you’re interested in exploring its potential, stick around. We’ll teach you the important details you’ll need to know in order to get started.
The Structure of Put Options
A put option contract consists of an agreement to possibly sell shares of the underlying stock. The sell price (known as a strike price) is predetermined. Options contracts are also open for only a predetermined amount of time. Once the contract expires (on its expiration date), it’s essentially worthless. And in order to enter this arrangement, you have to pay a fee (this is known as the premium).
There are two main reasons someone would buy put options. It can be a hedge to protect an investment or – more likely – an attempt to profit on the underlying stock dropping.
Selling puts is different. When you sell put options, you agree to potentially buy shares of the underlying stock. And you do so at a set strike price by the expiration date. And for your troubles, you are rewarded with a premium payment from the buyer.
Because the end goal for many put sellers is to buy the underlying shares of the options contract, it makes sense to engage in selling put options only of a company you want (and are willing and able) to own shares of.
Next we’ll look at a breakdown of what a successful put selling strategy would look like.
Selling Put Options of Your Favorite Stock
We’re big fans of the biopharmaceutical company AbbVie (NYSE: ABBV). The company has a good product line, a strong pipeline of future products and a healthy dividend. But AbbVie is also trading near its 52-week high. We like the company. But we’d prefer shares were a little cheaper. That leaves us with two routes to take.
One way is to head to head over to our brokerage account and place a buy limit order for AbbVie. This allows us to set the price we’re willing to buy shares for. But if shares never fall to the limit price, the order won’t be executed. And we’ll just be sitting on my hands the whole time, hoping for the best.
The second route is selling puts. I can sell a put contract with a strike price close to what my limit price would be. And I get to decide how far in the future I’d like to keep this contract open.
Looking a couple of years into the future, AbbVie put contracts with a strike price 15% less than its current share price are going for about $32. First comes the passive income part of the equation. If I can sell a contract for $32, I collect $3,200 right off the bat because each contract controls 100 shares.
I’m free to do whatever I want to with that $3,200. And if/when AbbVie drops to the strike price I sold the contract at or below, I might get to buy 100 shares at the discounted price I was hoping for. Like we said at the top, selling put options is like getting paid for the chance to buy discounted shares of the stock you like. Or, to put it another way, it’s like getting paid to have a buy limit order on your stock of choice.
When the Stock Never Falls
Now let’s plug in some hard numbers. In this scenario, let’s say AbbVie is trading for $150 a share. But we want to pay $135 a share. We can sell a put contract with a strike price of $135 that expires in one year and collect the premium. If AbbVie’s share price falls to $135 or less, we can be required to buy 100 shares at $135 per share. And just like that, we’ve got a great new addition to our portfolio at a discount.
But if AbbVie’s share price never drops below the strike price, the contract will most likely expire worthlessly. We still get to keep the premium we were paid upfront, but we aren’t called upon to buy 100 shares. No big deal. We still brought in a little passive income up front.
Selling Put Options: The Bottom Line
Not every investor is automatically able to sell puts through their brokerage account. You need to be approved to sell puts. Another great way to maximize your potential earning power is to sell puts through a margin account.
If you were to sell puts in a cash account, you’d need to keep enough cash in your account to be able to cover shares you could be required to buy. But in most margin accounts, you need only 20% of the necessary cash in your account while the option contract is open. If your contract gets exercised, the brokerage will temporarily cover the tab until you pay it back. By doing this, you can keep more of your money out there working for you.
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About Matthew Makowski
Matthew Makowski is a senior research analyst and writer at Investment U. He has been studying and writing about the markets for 20 years. Equally comfortable identifying value stocks as he is discounts in the crypto markets, Matthew began mining Bitcoin in 2011 and has since honed his focus on the cryptocurrency markets as a whole. He is a graduate of Rutgers University and lives in Colorado with his dogs Dorito and Pretzel.