Selling put options is a great way to generate income. I use it extensively in my portfolio to get a consistent stream of income. In fact, I look forward to the 3rd week of every month as my put options expire worthless and I can officially add the premiums collected to my earnings. My goal is to generate monthly income of at least 1% of my total portfolio value. This means an annual return of 12% or more.
Below are some reasons why I love selling put options.
You can be wrong
You don't have to be 100% right on an options trade to make money. Consider Intel (NASDAQ:INTC) for example. If you were to buy INTC today at $22 a share, you hope that it will move up in the near future so you can sell at a profit. You have effectively committed yourself and your capital at $22 a share and will be subject to all the ups and downs of the market. You hope that the stock has found a bottom and will not drop another 10%. If it does drop, you have no choice but to sell at a loss, or wait until the stock recovers.
On the other hand, if you sold a Jan 2013 $20 put option for $0.40 a contract, your effective entry price is $19.60. This gives you a 10% downside protection from now to January 19 2013. Even if you are totally wrong with INTC and it tanks to $18 (lows we have not seen since 2010), you can always roll forward and down your put option to, say, April 2013 and still make a profit from the trade.
You can be lazy
Once you committed to a put option, there's not much you need to do. You can monitor the underlying stock once or twice a day and that will be sufficient. For the most time, you can sit back and watch the passage of time do the work for you since time decay will gradually decrease the value of the put option.
When sufficient time has passed, or when the market moves in your favor, you can consider buying back the put contract to free up your capital. You can then deploy your capital by selling put contracts on another stock.
You look forward to market downturns
Perhaps this just applies to me only, but I look forward to days where the market drops 1~2% as a result of panic-induced global selling. This is usually the best time to sell put options since volatility (aka fear) is at a high. I would scour through my watchlist to find stocks that are being oversold, and sell puts with strike price near a support line. As volatility drops over the next few days as the market gains equilibrium again, you will be left with a small gain in your positions.
You can make use of your margin
You will be required to put up some capital as margin when you sell put options. The margin requirement varies with the underlying price and options price, but will typically be capped at the strike price * 100 per contract. So if you sold one $20 PUT option, the maximum margin requirement you would expect is $2000 ($20 * 100). Does this mean you must have cash sitting there idly?
You can actually invest a portion of the cash you put up as margin into low-beta dividend paying stocks or ETFs to earn an extra 3~4% yield per year. Being Canadian, a portion of my margin requirement is made up of dividend-paying stocks such as Rogers Sugar and interest-paying bond ETFs such as Canadian 1-5 year corporate bond fund. This more than offsets my trading expenses, and leaves me with some nice pocket change.
Keep in mind that for a typical margin trading account, 30% of the equity value will be added to your initial and maintenance margin, leaving only 70% of the market value you can use to offset the margin requirements of your put options. I would recommend keeping a portion of your margin requirement in cash (30% at least) in case the underlying stocks or ETFs you hold suddenly lose value along with the rest of the market. The last thing you want is a margin call during a market downturn.
I hope some of the examples I listed above can encourage those who are interested in generating regular income to explore the world of put option selling. Remember to do your due diligence and happy trading.
Disclosure: I am long INTC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long INTC via various short put options.