An investor usually sells a put option if his/her outlook on the underlying security is bullish. The buyer of the put option pays the seller a premium for the right to sell the shares at an agreed-upon price. If the stock does not trade at or below the agreed-upon price (strike price), the seller gets to keep the premium.
Benefits associated with selling puts
- In essence, you get paid for entering a "limit order" for a stock or stocks you would not mind owning.
- It allows one to generate income in a neutral or rising market.
- Acquiring stocks via short puts is a widely used strategy by many retail traders and is considered to be one of the most conservative option strategies. This strategy is very similar to the covered call strategy.
- The safest option is to make sure the put is "cash secured." This simply means that you have enough cash in the account to purchase that specific stock if it trades below the strike price. Your final price would be a tad bit lower when you add the premium you were paid up front into the equation. For example, if you sold a put at a strike of 20 with two months of time left on it for $2.50; $250 per contract would be deposited in your account.
- Time is on your side. Every day you profit via time decay as long as the stock price does not drop significantly. In the event it does drop below the strike you sold the put at, you get to buy a stock you like at the price you wanted. Time decay is the greatest in the front month.
Suggested Put Strategy for Cummins Inc (CMI):
The stock is attempting to put in a bottom in the $89.50-$90 range. This zone has been tested twice in the past 30 days and on each occasion, it has held. Wait for the stock to pull back to the 93.00 ranges and then sell the Jan 2013, 90 puts. If the stock pulls back to the stated ranges, these puts should rise in value from $0.80-1.10. For this example, we will assume that these puts can be sold for $9.00. For each contract sold, $900 will be deposited into your account.
If the stock trades below the strike price, the shares could be put to you (assigned to your account). In this case, you will have the opportunity of getting into this stock at a much lower price. Your final price when the premium is factored in will work out to $81 per share. If the stock is not assigned to your account, you walk away with a gain of 10% in roughly 7 months.
Your potential Risk
Investors only sell puts when they are bullish on the stock, and as such they are prepared for the possibility that the shares could be put to them (assigned to your account )in the event they traded below the strike price. Hence the only risk factor is that you have a change of heart after selling the puts. Perhaps you now feel that the stock could trade well below the strike price. In this case, you can roll the put. Purchase the put you sold back and sell new slightly out of the money puts. Note your break-even point for this trade is $81.
Only implement this strategy if you are bullish on the stock, and you are ready for the possibility that the shares could be put to you. Selling puts is one of the better methods of getting into a stock you are bullish on. You either get in at a lower price, or you get paid for trying to.
Sources: EPS and Price Vs. industry charts obtained from zacks.com. A major portion of the historical/research data used in this article was obtained from zacks.com. Options tables sourced from money.msn.com.
Disclaimer: It is imperative that you do your due diligence and then determine if the above strategy meets with your risk tolerance levels. The Latin maxim caveat emptor applies - let the buyer beware.