Why I Sell Put Options (Part I)

In this post I share why I never set market orders and rarely set limit orders when purchasing stocks and ETFs. To understand this post you'll need somewhat of a background in stock options. To learn more about options and, how options can help protect your portfolio, and allow you to speculate with less money up front click here.

The first rule of serious investing is never set market orders! Never set market especially when the volume on the stock is light. If the last price of a stock was $8.50, many investors may think that's the price they are going to pay. However if the current bid is $8.25 and current ask is $9 and you place an order to buy at market, you will buy at $9 (If you want more than what is offered, you'll at least fill the quantity offered at that price).

So why not use a limit? When trying to buy a stock I'll use the PUT option. If a stock is at 50 and I wanted to pay 45, I will then simply sell the closest to expiration put option contract for the 45 strike. I will then get a premium, and if the stock is below the price I want to pay, when the contract expires, I get the stock at the price I would have picked it up at anyway (price I would use to place the limit order). This helps get into the position cheaper, and if you're like the old me (before I used this strategy) and set limit orders which automatically cancel at the end of the day; how many times have you forgot to replace that order on the following day?

How many times have you placed a limit order just to watch it never get filled? Well if you sell the put option you'll receive a premium, so if you don't get the stock at your set price, at least you keep the premium. A way to look at it is you're getting "free money" if the option expires above the strike.

Obviously you wouldn't use this strategy if you were buying less than 100 shares, or if you absolutely "needed the stock today" in your portfolio. The trade off is, if the stock trades at or below what your limit order would have been, and takes off to the upside, expiring above the strike, you don't get the stock nor gains from the stock, just the gain of the premium from selling the put option.

In order to get the stock, it needs to close below the strike on the given options expiration day in order to get the shares.

Another negative of selling the put option is that options are less liquid than stocks, meaning you won't be able to get in and out of the position as easily.

This is part one of two. In this post I will demonstrate this option strategy on a list of 25 popular stocks. In part two, I will show you this strategy using very volatile ETFs which I believe are safer than individual stocks, believe it or not.

All data as of market close Friday July 17, 2009.

HOW TO READ THE TABLE

NOTE: When using this strategy, I first decide what I am willing to pay for the stock. Let's keep it simple and say I'm willing to buy the stock at a share price of 5% lower.

Terms used in table:

• Price: The most recent closing price (last quote price) for the stock
• 5%: The price which I am willing to pay for the stock which is 5% lower than the closing price
• Strike: The closest contract strike price to the 5% lower price. It may be slightly higher or slightly lower than the 5% lower price.
• Prem.: This is the theoretical premium received from selling the put option
• Adj. Cost: This is the adjusted cost for the stock, if you do happen to end up with the shares at expiration.

The first stock listed in the table below is Apple (AAPL). An example of this option strategy on AAPL would be interpreted as:

Sell the Apple (AAPL) August 145 put option. This will give you $2.36 a share for Apple. If Apple expires above the indicated strike price you profit 100% of the premium received, if not your cost per share of the stock is $142.64, 6% lower than the close price and 1% lower than the price I was willing to pay.

All but one of these options expire on August 22; therefore the last trading day is Friday, August 21, 2009. The Sirius strategy from the table above expires in December. The Sirius Satellite Radio December $1 Put is an interesting play I have been watching and blogging about on OptionMaestro.com. If you wanted to go long Sirius, it may be a good idea to sell this Put, as it will get you in the stock 12.5% below the current share price and give you a lot of room to the upside in case it starts to rally.

These are just examples and are not recommendations to buy or sell any security; if you're more bullish/bearish, you’ll want to adjust the strike price and expiration accordingly.

I've been using this strategy to purchase my shares and I find it has been working well. It's a bad idea to use this strategy as a form of speculation, in other words selling a put for the premium just because you think a stock will never get to a lower strike by options expiration. Remember even if the stock goes to $0 a share, you're still obligated to buy it for the indicated strike.

To learn more about selling puts and other option strategies check out my option trading books.

Disclosure: Long BAC, CAT, GS, GOOG, PALM, SIRI, V

Comments

[skwestorange:]

Perhaps you should at least mention the fact that this is naked put sell that has option requirement that is marked to market daily. In down trending market this alone could put a lot of stress in the account. Also mention that the account must be approved for such option selling before it can be done.

Jul 20 09:19 AM

[little lenny:]

In addition, the account must lock up the total put value as cash. Even so, sounds great especially when you are a long term invester.

Jul 20 10:39 AM

[Paul Zimbardo:]

I have been selling cash-secured puts for over a year now and I find them a great tool that I have added to my bag of trading skills. Good post but I believe that you should stress a few points:

1. The biggest risk involved in selling cash-secured puts is the “catching a falling knife phenomenon”. This scenario happens when you sell a put and the stock price falls far below the strike price of the put. If this scenario materializes, you will be forced to be the stock at the strike price, often far above the current market price of the stock. This often happens when bad news or poor earnings are reported before the exercise date. Therefore it is important to always check the economic calendar of any stock you are selling a put on. For example, AAPL reports earnings tomorrow. If you sell the $145 put and AAPL reports disappointing numbers, you could easily be forced to buy the stock at $145 when it is trading at a much lower price.

2. Since you do not own the stock, you are not entitled to any dividends, nor do you have the ability to sell covered calls to generate income on the position.

3. Selling puts often requires account approval from your brokerage provider.

Jul 20 10:49 AM

[joliver:]

I believe you had said you were buying at market usually 100 shares, then selling put instead of at limit order is this true or are you saying you buy these naked?

Jul 20 11:36 AM

[jmsithy:]

I was selling these in blocks at 174 and 349 shares when this was between .39 and .40 to see how much I could aquire then buy back in at .36


On Jul 20 11:36 AM joliver wrote:

> I believe you had said you were buying at market usually 100 shares,
> then selling put instead of at limit order is this true or are you
> saying you buy these naked?

Jul 20 12:12 PM

[tacowolf:]

As a naked put seller, the other two tools you have are:
1. If it appears that the stock will be put to you, you can cover your position and rewrite the put. As an example, I sold July $95's on POT, three day before the strike date it was @ $88. I bought back the put @ $7.5 and sold September $85's @ $10.50. So rolling it forward I picked up an additional $3.00 premium plus the original $3.50 I sold the July $95 for. Obviously if the stock was below $85 in September I would have to do the same exercise.

2. The other tool would be to take the stock in and sell a call for it about 2-3 months out at the original strike price. If the stock reaches that strike you lose the stock and have the original put premium and the call premium. Several months ago, I sold GIS $50's for $1.80. Bad news came out 2 weeks before the strike date and the stock tumbled to $46. I took the stock in and wrote $55 calls on it for for $2.00. I lost the stock in July when it was trading @ $57. Still had both premiums and a dividend. I had an annualized return of over 24%.

Naked put selling as an income strategy works well in bull markets or in markets that are going no where. Additionally, selling puts on "dead stocks" with long expiration dates is not a bad strategy. Selling January $42.50's on KO gets you a premium of $1.75. It's trading at $50.20 now. Would you mind owning KO @ $40.75? I wouldn't! KO has traded in a very narrow range over the last 6 months $44-50. Use this strategy on stocks that you would want in your portfolio. It is not a speculative strategy. Regarding margin requirements, some brokerages require as much as a 20% of the value of the puts if exercised or a per contract requirement.


On Jul 20 10:49 AM Paul Zimbardo wrote:

> I have been selling cash-secured puts for over a year now and I find
> them a great tool that I have added to my bag of trading skills.
> Good post but I believe that you should stress a few points:
>
> 1. The biggest risk involved in selling cash-secured puts is the
> “catching a falling knife phenomenon”. This scenario happens when
> you sell a put and the stock price falls far below the strike price
> of the put. If this scenario materializes, you will be forced to
> be the stock at the strike price, often far above the current market
> price of the stock. This often happens when bad news or poor earnings
> are reported before the exercise date. Therefore it is important
> to always check the economic calendar of any stock you are selling
> a put on. For example, AAPL reports earnings tomorrow. If you sell
> the $145 put and AAPL reports disappointing numbers, you could easily
> be forced to buy the stock at $145 when it is trading at a much lower
> price.
>
> 2. Since you do not own the stock, you are not entitled to any dividends,
> nor do you have the ability to sell covered calls to generate income
> on the position.
>
> 3. Selling puts often requires account approval from your brokerage
> provider.

Jul 20 01:29 PM

[mtd:]

How this can go wrong:

Stock A and B are trading at $10. You buy both at market. Stock A loses $5 and Stock B gains $10.

Your portfolio gains/losses
Stock A ($5)
Stock B $10
P&L $5

If you had done this with selling puts @ $9 (say for a $1). Since Stock B took off, you would have never purchased it. Stock B on the other had has dropped and you have been forced to pay $9 for it.

Your portfolio:
Stock A ($4)
Put premium $1
P&L ($3)

Jul 20 07:34 PM

[captainccs:]

Both A & B go down 5, you lose 10
The put seller loses 8

On Jul 20 07:34 PM mtd wrote:

> How this can go wrong:
>
> Stock A and B are trading at $10. You buy both at market. Stock A
> loses $5 and Stock B gains $10.
>
> Your portfolio gains/losses
> Stock A ($5)
> Stock B $10
> P&L $5
>
> If you had done this with selling puts @ $9 (say for a $1). Since
> Stock B took off, you would have never purchased it. Stock B on the
> other had has dropped and you have been forced to pay $9 for it.
>
>
> Your portfolio:
> Stock A ($4)
> Put premium $1
> P&L ($3)

Jul 20 09:36 PM

[Richard Graham:]

In terms of using market orders, you don't lose that much when the bid/ask spreads are tight (usually a couple of cents). This is true in most heavily traded stocks. With options, contrastingly, spreads are usually wider, so you do need to place a limit order in order to get the more favorable ask price instead of the bid. This is particularly necessary for far out of the money options.

Jul 21 02:22 AM

[rrtzmd:]

...if it works for you -- great!...HOWEVER, my own personal experience is that keeping things SIMPLE ultimately works best...the more complicated the product, the more of YOUR money goes to some middle man...moreover, the options market is something kin to a casino...an investor is betting against institutions filled with supercomputers and trained professionals...not exactly a friendly place for individual speculators...

Jul 21 08:51 AM

[connorport:]

Unless you purchase the stock for the price you are ok with and use covered calls to margin down or lock on a certain profit you can live with. I myself like to use this method of trading.


On Jul 21 08:51 AM rrtzmd wrote:

> ...if it works for you -- great!...HOWEVER, my own personal experience
> is that keeping things SIMPLE ultimately works best...the more complicated
> the product, the more of YOUR money goes to some middle man...moreover,
> the options market is something kin to a casino...an investor is
> betting against institutions filled with supercomputers and trained
> professionals...not exactly a friendly place for individual speculators...

Jul 21 09:45 AM

[Matthew Lat...:]

I'm glad you wrote the article that you did instead of an article about the risks of using options. I'm tired of reading the same retread in every options article.. check withyour broker, options are risky, etc etc etc.

On a positive note, thanks to everyone chipping in to add additional strategies for the put sell, it benefits us all. Especially like the 'falling knife' strategy, where you can double down and pick up additional hundreds of shares and premiums on the way before writing out covered calls with longer expirations on the way back up.

Jul 21 01:25 PM

[helplessobs...:]

I personally like the strangle, buy the stock, sell a call on it and then sell a put, both near the money. If the stock gets called a 8-10% premium profits is gained. If the stock declines the premiums give a 6-8% discount from the buy. Below your break even price buy two out of the money puts to protect your capital. A strike on Iran will cause a 500 - 800 drop on the DJIA. I use an Excel spread sheet model to quickly compute profits, percentages and break even prices.

Jul 21 06:24 PM

[Mark123:]

I have been doing the same thing for 10+ years.... a few loosers, but overall gainers.... Quit my job almost 11 years ago to do this exact strategy.....

Jul 22 12:28 PM

[thevoice@vo...:]

Since we are on the topic of selling puts take a look at Hasbro:

(HAS) surprised analysts by trimming the cost of the Discovery Communications joint venture and reporting a 5% increase in profits over a year earlier. So far this year HAS is down 9% while its main rival, Mattel (MAT) is up 13%, I expect Hasbro to catch up by year end. Below are two strategies to play the recent earnings which will leave room for a 23% and 32% downside protection from current levels. Keep in mind the lowest price HAS hit was $21.14 during the March market collapse. Both of the below strategies take this into consideration and the price of the stock would need to fall under $20 to realize a loss in one and under $17.50 to realize a loss in the other.

For a return of 50% over six months, sell 10 Jan10 Put contracts @ $20 for a premium of .50 cents. The margin requirement would be $2,500.00 less the premium proceeds of $500.00 for a total requirement of $2,000.00. This trade nets $500.00 for a yearly gain of 25% or if entered into today, 50% as there are only 6 months left until expiration. Downside protection of 23%.

Jul 23 08:03 PM

[goldnpaw:]

which strategy Mark? The original post or "helplesssobs"??


On Jul 22 12:28 PM Mark123 wrote:

> I have been doing the same thing for 10+ years.... a few loosers,
> but overall gainers.... Quit my job almost 11 years ago to do this
> exact strategy.....

Jul 29 03:49 PM

[Options Tra...:]

Nice article. Writing put options does have its advantages albiet limited profitability.

Oct 30 09:05 PM