Selling Put Options can help you reduce your risk while drastically increasing the income you receive buying stocks. We explained put options here.
Today, Let’s look at an example to explain the moving parts…
Puts for Feb 19 2011
Strike Last Change Bid Ask Volume Open Int
19 0.21 -0.01 0.20 0.21 63 884
20 0.39 0.00 0.38 0.39 2,149 5,365
We’ve listed two different Put Options with an expiration date of February 19th(obviously outdated). This is slightly less than two months from the day of this information. You can see that you could sell a Put Option with a Strike Price of 20 and receive 38 cents per share. This means you would receive $38 for agreeing to buy Intel at $20 if the price is below that level on February 19th. In other words, you have to tie up enough money to buy 100 shares of Intel at $20 for two months. This is $2000. A $38 return on $2000 tied up is 1.9% over a two month period. If you were able to repeat this exact type of Put Option sale every two months, this works out to $228 per year which equals 11.4% per year.
Some Option services will hype a trade of this type by saying it achieves a 57% annualized return, but we don’t subscribe to their logic. The reason they’ll say this is because many brokerage firms only require you to hold 20% of the amount of money that is needed to buy the stock you are pledging to buy if the option is exercised. In this case, $400. If you use a brokerage firm with these rules, you only need to maintain a cash balance of $400, and in turn you can earn $38 on it. This is a 9.5% return in only two months. However, if the stock price falls and you are required to buy the shares, you will have to come up with the full $2000 to buy them. Therefore, we think this type of accounting is simply hype.
One thing that’s important to again mention is that at the time this section was written, volatility was extremely low. Higher volatility indicates higher option prices and therefore more profit for the seller of options (as well as more chance that you actually have to buy the stock because the stock market is probably falling). If you plan to continually sell these options, you’ll receive different prices for the same type of option depending on the volatility in the market. When volatility is higher, you’ll receive more to sell an option. If prices continue to fall (which they probably were if volatility is higher) then you will probably end up owning the shares which you had sold the put option for.
Let’s look at the different scenarios that can happen…
1) The Put Option expires worthless. This happens if the current market price is above the strike price ($20) for Intel on the expiration date (Feb 19th). This is fantastic because you were paid income up front and now that the time of the option is over, you are no longer obligated to anything. You can forget all about the stock and option, or you can repeat and sell another put option.
2) The Put Option is exercised. In this case, you were paid money up front and then you were obligated to buy the stock at the agreed upon price ($20) on the expiration date (Feb 19th). This is also fantastic news because you were about to buy Intel at $21.47. Now, you were paid 1.9% ($38) and then bought Intel instead for 7.35% less than you were willing to pay. Add up your income and your discount and you have a 9.25% advantage over what would have happened if you had simply bought the stock outright at $21.47. Imagine if you were able to repeat this option trade for a full year before you were finally “put” the stock? You would have 11.4% in income plus the 7.35% discount for a total profit of 18.75% on the first day that you become the owner of the stock!
Let’s look at the other option listed above. It’s a $19 Strike Price Option. You can see that it’s selling for half the price of the $20 Option. So it yields half as much, but is less likely to be exercised. You would be paid $20 up front for your promise to buy 100 shares of Intel at $19 (obligating yourself to a $1900 purchase) on Feb 19th. This is only half the income that the $20 Option promised. The advantage is that it’s much less likely that Intel falls below $19, than it is that it falls below $20. If Intel falls to $19.50 on Feb 19th, then the sellers of $20 Put Options will have to (get to?) buy the stock at $20. The sellers of $19 Put Options will see their options expire worthless.
This is Post 7 of a new series on stock options which we’ll be revisiting every few days. You can find the first few parts at the following links: Pt 1, Pt 2, Pt 3, & Pt 4, Pt 5, & Pt 6.