I’m going to show you how to get paid to buy stocks at a price you want. Instead of purchasing the stock, you can have someone actually pay you for a contract that gives them the right to sell your favorite stock.
This strategy will allow you to either collect on overpriced stock option premiums, and/or buy your stock at a discount. It’s a strategy called selling naked puts.
11 Secrets of Naked Option Writing
Selling Naked Puts
When you “sell to open” put options, which is also known as “selling naked” because you don’t own the underlying shares, you are taking on the same risk that you would when you buy the stock outright (minus the amount of money that you received for selling the put option, which really means you are taking on even less risk than outright stock ownership).
So if someone pays you $2 for a put option that you sell them, this put option gives the guy the right (but not the obligation) to sell you XYZ stock at $50. So, the risk you are taking in this position is the same risk you would have taken if you bought XYZ at $50, minus the $2 that you’re getting paid ($50 – $2 = $48).
In fact, the risk and reward are exactly the same as when you sell covered calls on a stock position you own. If you understand the covered call strategy (i.e., selling call options against your long shares), then you should have no problem understanding the risk and reward of naked puts.
If you are comfortable with covered calls, then you are comfortable with naked puts. The only difference is that there is less cash outlay in naked puts. Just like covered calls, the profit is limited when you sell a naked put option.
When you buy a stock, you only profit when the stock moves higher. When you sell the naked put, you can profit when the stock moves up, sideways or even down by a small amount. So, when you sell naked puts, your profit potential is limited, but it is more likely that you make a profit.
However, if you sell/write a naked put option and it’s exercised (i.e., the put owner decides to exercise his right to “put” shares to you at the strike price of the option), you’ll be obligated to buy the stock — in which case you’ll have unlimited upside potential.
The Mechanics of Selling Naked Puts
If you buy 100 shares of XYZ at $30, you’ll pay $3,000. Or you can have someone pay you $200 for their right to sell you 100 shares XYZ at $30. (This would actually give you a cost basis or breakeven point of $28.)
Put Buyers
One XYZ March 30 Put option allows the owner of the put option to sell 100 shares of XYZ at $30 per share at any point between now and the third Friday of March, which is the last trading day before the option expires. (Find out why options don’t expire on Fridays like most people think.)
The owner of a put owns the right to sell a stock at a certain price, and the seller (writer) of the put promises to buy a stock at a certain price if the owner of the put decides that’s what he wants to do.
Sometimes put options are used as “insurance” against a possible decline in a stock.
If Bob owns XYZ stock, which is at $30, but is afraid the stock might drop significantly, he may purchase the right to sell XYZ at $30 by buying a put option.
Let’s say Bob purchased the put option for $1.10. Since options prices are quoted per share, and an options contract represents 100 shares, Bob is paying $110 for one contract.
In other words, he gave up $110 for the peace of mind of knowing that, if XYZ drops to $15, he will exercise his right to sell XYZ at $30 (even though it trades in the market for $15). So Bob paid $110 for that insurance.
But what if Bob was incredibly frightened by the stock market because overseas markets dropped by 8% overnight? Well, he might be willing to pay $2 per put option ($200 instead of $110).
There is a whole market full of people like Bob out there. This explains how options become more expensive in a scary market. And you want to sell options when prices are high and buy options when they’re low.
Naked Put Sellers
Now that we’ve gone over the concept of put options from the buyer’s point of view (the buyer/owner has the right to sell stock at a certain price), let’s consider the benefits of being the seller/writer of put options (which means that you are accepting payment in return for your obligation to buy the stock at a certain price).
Traditionally, a person who thinks XYZ will trade higher might buy 100 shares at the recent price of $16.98.
But if you like XYZ you might instead sell (write) the XYZ March 17 Put options. This means you are accepting the obligation to buy XYZ from someone at $17 per share if they decide to sell it to you before the expiration day (the third Friday of the month).
Ninety-nine percent of the time, when someone buys a put option, they will only exercise it (use their right to sell XYZ to you at $17) when the stock falls below the strike price (of $17).
If the XYZ March 17 Puts are trading at $1 – $1.05, then someone is willing to pay you $100 for the right to sell 100 shares of XYZ to you at $17 at some point before the expiration day.
Benefits of Short Naked Puts
First off, if you are already considering the purchase of XYZ at $16.98, then you wouldn’t mind if someone first paid you $100 for the put option, and then sold you XYZ for $17 (probably because it went down).
The math is simple. If you buy 100 shares of XYZ at $17 after someone has paid you $100 for selling them the put option, you have really purchased 100 shares of XYZ for $16 a share (not including trading expenses).
Intrinsic vs. Extrinsic Value
In our example, the strike price is $17. Therefore, the option is considered to be in-the-money by the amount that XYZ is trading under $17.
So if XYZ is at $16.50, the XYZ March 17 Puts are 50 cents in the money. If XYZ is at $14, the March 17 Puts are $3 in the money, and so on.
The amount by which an option is in the money is referred to as “intrinsic value.”
To understand the advantages of selling options, it’s important to understand “extrinsic value,” aka “time value.”
Options lose their extrinsic value as time passes. The extrinsic value of an option’s price might account for some of an option’s price, part of an option’s price, or all of an option’s price. Therefore, an option seller/writer benefits from the deterioration of extrinsic value due to time passing — a process known as time decay.
Extrinsic value (time value) = the price of the option – the amount by which the option is in the money
If XYZ is at $16.98, that means the March 17 put is 2 cents in the money. Since the March 17 put costs $1 per put option, we know that that put option has 98 cents of extrinsic value ($1 put option – 2 cents intrinsic value = 98 cents extrinsic value).
When you sell/write an option, you want to do so with an option that has lots of extrinsic value because as the process known as time decay happens, the seller of the put option profits.
Key point: Time decay benefits the seller/writer of an option whether the stock and option moves up, down or sideways. Either way, time decay is happening.
After you sell/write a put option, there are three possible outcomes:
Outcome No. 1: The Stock Moves Up
If this happens, the put option that you have sold/written will lose value. And this is a good thing because when you sell/write a put option to open, you have essentially sold short a put option. And when you sell short something that loses value, you are making money.
For example: If you sell something at $1 and buy it back at 25 cents, you make a profit of 75 cents. So if the stock moves higher, causing the put option you have sold at $1 to move lower to 25 cents, you can buy that put option back. You would enter the order as a “buy to close.” If you purchase the put option to close, you will have closed out the position, and you will no longer have an obligation to anyone to buy XYZ at $17 per share. The trade is done and the contract ceases to exist.
In this scenario, you have two things working in your favor: XYZ is moving higher, and time is passing — both of which cause the put option you have sold to lose value.
There is one other bonus that most people don’t think about. Because the stock started moving higher (or stopped tanking) people became less fearful, causing the put option to get even cheaper. As we’ve just said, fear is what causes people’s willingness to pay even higher prices to buy options. When the put option you have sold gets cheaper, you can also choose to NOT make any closing put option trades.
If XYZ is above $17 a share when the March 17 put option expires, the put option will have expired worthless, and you will no longer have an obligation to anyone to buy XYZ.
But if the stock moves back down below $17, someone may exercise their put option and therefore sell you XYZ at $17.
Remember, your breakeven price of XYZ is now $16 ($17 purchase price – $1 premium received for the put option you sold/wrote).
Outcome No. 2: The Stock Moves Down
If this happens, the put option that you have sold/written will increase in value.
Now this is different than when you sell short a stock that moves higher because, in this case of being the seller/writer of a put option, your position is NOT losing value.
Instead, you can be sure that someone who owns the XYZ March 17 Puts (who remains anonymous) would exercise their right to sell XYZ to you at $17.
When this happens, you will check your stock account and you will notice that you have automatically bought 100 shares of XYZ at $17 (even though it is trading in the market at a price lower than $17).
You shouldn’t have a problem with this scenario because you were willing to buy XYZ when it was trading at $16.98 anyway, right? Now you will have bought it at $17 after receiving $100 for the put option you sold.
This means that, although you were going to spend $1,698 on XYZ stock, you have now spent $1,600 ($1,700 when someone exercised their put minus the $100 you received from the person who bought the put option you sold).
Outcome No.3: The Stock Moves Sideways
Chances are the stock won’t be at exactly $16.98, but for the sake of the explanation, since XYZ is at $16.98, the put option will probably expire worthless.
This means that you collected $100 and, if you like, you can repeat this process again and again … collecting more premium each month.
Special Note
When selling/writing naked puts, it makes sense to sell the put option that expires within 45 days and the one that has the closest strike price.
In my XYZ example, the stock was at $16.98, so the closest strike price was the March 17 put. Since XYZ was 2 cents lower than $17, it was 2 cents in the money.
If you still find this strategy confusing, it pays to read up on it more. If you have never done this before, ask for some help from your broker, and be sure to understand the cash requirements (in the case that the put option is exercised and you end up buying the stock).
