Everyone likes to make money. It’s the reason why we trade and invest in the stock market, and there’s a way to make money just for your agreement to buy a stock at a price of your choice.
Well, a simple stock option trade pays you to do just that. It is selling naked put options. Naked put-selling allows you to enter into an agreement to buy any stock you want at practically any price you want. And someone will pay you to do it.
One of the best qualities of this strategy is that you control all the terms. You get to pick the stock, you get to pick the price at which you’re willing to buy the stock, and you get to pick the duration of the agreement. You have full control going in.
Although options come in two types: call options and put options, we’ll only discuss put options today. All option contracts have:
- A term length (expiration date)
- An agreed upon price at which the stock can change hands (strike price)
- A fee that the option buyer must pay to the option seller (premium).
For every options contract, there’s always a buyer and a seller. As the put-seller, your goal is to choose a stock you want to buy at a price in which you’d be happy to buy it. The key to doing that successfully is to choose a price that is well below the stock’s current price. This will allow you to get a bargain if you’re called upon to execute your end of the agreement. In the end, there are only two outcomes: either the stock falls in price to your level or it doesn’t.
If it falls in price to your level or below, you follow through on your agreement and buy the stock (you get to “put” the stock). You get to buy the stock at the price you want.
If it doesn’t fall to your level, the put expires worthless for the option buyer and although you walk away from the deal with no transaction occurring, you still get to keep the premium.
No matter which outcome occurs at expiration, you always get paid the premium upfront by the put-buyer and you get to keep that money no matter where the stock trades during the life of the transaction.
There is a two-step process to doing it successfully. The first step is to pick a stock you’d like to buy at a much cheaper level than where it currently trades. The second step is to select the price and an expiration date and sell the corresponding put that matches your criteria. Then you wait to see what happens on expiration day.
Selling puts on IBM
If IBM is a stock you have on your radar and your ideal buy point would be near the lows it hit back in early 2016 of around $130 per share, what can you do? (See “Waiting for a pullback,” below).
Since it’s currently trading near $182 per share, you have two choices: You can place a limit buy order to purchase the stock if it falls back to $130, or you can sell a $130 put and collect the premium.
Selling a $130 put doesn’t mean you will own the stock, but does pay you for your trouble. “Bargain shopping” (below) shows prices of the October 2017 IBM puts as of mid-February.
The market for the 130 puts is $1.14 bid/$1.30 offer. If we split the bid/ask price, we get a fair value of roughly $1.22 per option. That means you can receive $122 from the put-buyer for every put you sell. If you sell 10 contracts you can receive $1,220.
Now, before you start thinking why not sell as many as I can, here’s the deal. Each option contract represents 100 shares of stock. When you sell a put, you are agreeing to buy 100 shares of IBM at $130 per share if IBM falls below $130 by the October 2017 expiration date. That will potentially require an outlay of $13,000. In exchange for your agreement, you receive $122 upfront.
If you sell 10 contracts, you will receive $1,220, but now you are agreeing to potentially buy 1,000 shares of IBM at $130, for a total outlay at expiration of $130,000.
You need to stay within your comfort zone and need to stay within your budget. Don’t get swept up in the amount of money you can receive. That’s a fast way to getting in over your head.
Why did we pick the October 2017 expiration? You can choose any time frame you like. It’s a balancing act between the strike price you’re looking at versus how much premium you can collect.
In order to sell naked puts, you will need the proper approval from your broker. Usually this entails filling out an extra form to let them know what your intentions are. In addition to getting the approval, the best type of account to execute these trades in is by using a “margin” account.
You won’t be using margin as it’s associated with borrowing stocks from your broker in which you typically pay interest, but as a futures style performance bond. Your broker will require you to have roughly 20% of what it costs to buy 100 shares in the form of cash or securities to cover the margin requirement.
In the IBM example, if you sold one $130 strike put you would need to have roughly $2,600 in your accounts to cover the trade while it’s open. That’s more than $10,000 less than covering the whole trade and a much better way to employ our funds.
If you purchased the shares at expiration, then you need the full $13,000 to cover the trade.
If you execute naked put-selling in a cash account or in an IRA, you will be required to hold the full 100% cost of the stock at all times. This is not ideal and my recommendation is to always trade these in a margin account. Each broker has slightly different terms, but most hover around the 20% margin level.
If IBM is trading above $130 at expiration, then the put-option will expire worthless and the trade is over. You have bought no stock but keep the premium and your margin is freed up.
Your best course of action after the option expires worthless is to repeat the process and sell another round of IBM puts at your desired level. This will bring in another round of premium. If IBM is trading below $130 at expiration, then you will be called upon to fulfill your agreement and purchase 100 shares of IBM at $130 per each option contract sold. Your broker will deposit the shares into your account and will debit you for the $13,000. Of course, you still get to keep the $122 you received upfront.
The end result here is that you got to purchase shares of a great company at a great price.
The strategy is very simple. If you know exactly what stock you’d like to buy and at what price, there are literally thousands of put-buyers ready, willing and able to pay you cash for your promise.
If done a certain way, a majority of these put-option contracts will expire worthless, allowing you to go months, if not years, of collecting constant streams of income without ever having to buy the stock. Many professional traders known as “options writers” employ this as a strategy as their goal is to simply collect premium; they don’t really want to ever own the stock. It has a reputation of producing consistent returns over time but they run the risk of it eventually backfiring on them as they’ll end up owning stock that they never wanted in the first place. In fact, they often will roll to a lower put and take a loss once the market goes against them to avoid having the underlying put to them. This is not the ideal method.
What are the risks?
As with any investment, there are always risks. But naked put-selling is actually no riskier than owning shares of stock. If you are required to fulfill your agreement and end up buying shares of stock that you wanted, what’s your risk?
The risk is the same with any stockholder -- that the price of the stock can go lower than your purchase price.
As mentioned previously, you only want to sell naked puts on stocks that you have a genuine interest in owning. Because you might actually end up owning the stock, and you should treat that investment with the same kind of risk management plan you already have in place for your other holdings.
The other risk is that you can get caught up in selling too many puts because you love the idea of getting paid premium.
Once again, be careful of the allure of that feature. Stick to your game plan and only sell the amount of option contracts that your account can handle and that you’re comfortable with in case you have to buy the shares.
Option prices do fluctuate, just like stock prices. This means that your put-option value can move higher or lower from your original sell price, causing you to entail a paper gain or loss while the trade is active.
If at any point you are no longer comfortable in the trade because your outlook has changed on the stock, you can unwind the option trade at any time. You don’t need to wait until expiration.
This would entail you buying back the put-option which will close out the trade completely. As a consequence, you may incur a loss (or profit), depending on where the stock and options are trading at that time.
Another way to limit risk is to enter a spread where you buy a put with the same expiration at a lower strike price. Using our IBM example, you could purchase an IBM 115 put for 67¢, the mid-point of the 115 put strike price in our “Bargain shopping” table. This is called an option credit spread. You would give up a little more than half of your premium ($122 – $67 = $55). However, if IBM implodes much lower and both options are exercised it would be the same as being stopped out at $115 (without the chance of slippage) except you keep the net premium credit (see “Hedging your bets,” below). You would be flat the stock. If IBM does not breach $130 you collect the net premium. If the 130 put is exercised but not the lower strike, you own the stock you wanted and can employ your regular risk measures. This also could reduce your margin requirement.
Making extra money just for your agreement to buy a stock you want at the price you want is readily available for you in the options market. Just pick your stock, pick your price, sell the put and collect your premium.
Remember, only choose stocks that you really want.
Lastly, in more cases than not, if you sell the put at a strike price that is far away from the current price of the stock, it will expire worthless. This allows you to keep selling the puts over and over.