The world of stock options beckons to investors one and all to come and get paid for making promises. It’s fascinating, really. Millions of stock enthusiasts are already actively buying and selling shares of stock at desired price levels for free. And therein lies a massive lost opportunity.
Consider these two common situations.
You own 100 shares of Apple Inc. (NASDAQ:AAPL) and want to sell them if AAPL rises to $120.
You want to buy 100 shares of Exxon Mobil Corporation (NYSE:XOM) if you can grab them at $80.
The typical approach would involve simply setting a sell limit order at $120 to unload your AAPL shares or setting a buy limit order at $80 to snatch up XOM shares. What if I told you someone was willing to pay you some cold, hard cash for simply promising to sell your shares of Apple if they rise to $120? Sounds like a win-win, no?
Or, on the flip side, what if you could get paid for promising to buy shares of XOM down at $80. Yet again, another win-win. You wanted to buy shares of Exxon Mobil anyways, so why not get paid for your willingness? Such opportunities lie in wait for those willing to embrace the power of stock options. The strategy where you receive payment for promising to sell your shares of stock is known as a covered call and was covered in-depth here.
Today, our attention turns to the world of put options, selling puts in particular.
Put Options Explained
To begin, a brief review of put option definitions is in order:
A put option gives the buyer of the contract the right, but not the obligation, to sell 100 shares of stock at a specific price on or before an expiration date.
Since the emphasis of today’s commentary is selling puts, we can reword the definition as follows:
A put option gives the seller of the contract the obligation to buy 100 shares of stock at a specific price on or before an expiration date.
Said simply, put sellers make a promise to buy shares of stock. If the stock drops below the put option strike price you will have to make good on your obligation and buy 100 shares of stock. If the stock sits above the put strike the option will expire worthless allowing you to pocket the premium you were paid up front.
For someone who was willing to buy shares of stock, it’s honestly a win-win. Worst-case, you end up buying a stock you wanted to accumulate anyways. Best-case, you score some income merely on your willingness to buy stock.
I’ll illustrate with a brief case study.
Put Option Example
Let’s say Twitter Inc (NYSE:TWTR) is perched at $28.40 and you’re neutral to bullish on the stock. Additionally, you don’t mind accumulating shares near the current price. Sounds like a great opportunity for selling puts. With 45 days remaining to expiration, you could sell the $25 strike put for 60 cents.
Now, consider the potential outcomes.
If TWTR stock remains above $25 by expiration, the put option will expire worthless allowing you to pocket the $60 (60 cents x 100). The max reward, then, is limited to the initial $60 received at trade entry.
If, on the other hand, Twitter were to fall below $25, placing the put option in-the-money, you would be required to buy 100 shares of stock at the $25 strike price. You do keep the initial 60 cents paid up front so your cost basis on the stock would actually be $24.40. The cost basis of $24.40 represents the max risk in the trade. If TWTR stock were to drop to zero, you would be on the hook for the whole $2,440 since that’s your cost basis for the shares you had to buy.
Bottom Line
We’ve only just scratched the surface of selling put options, so they definitely warrant some further exploration. In parting, let’s highlight the biggest advantages of this stock option strategy.
First, selling puts offers a high probability of profit. You win if the stock rises, travels sideways or even declines a bit.
Second, you profit from the passage of time. By shorting put options, you exploit the one constant in the stock options market — time decay.
Finally, selling puts allows you to exploit the overpricing of options. Stock options tend to be priced on the high side, giving option sellers a slight edge.
