Almost every week I’m asked, “What’s your favorite income strategy?”
Simply stated, my favorite income strategy is selling put options.
Here’s how selling puts actually works – and how using the strategy can boost your income in a safe and consistent way.
For instance, say you are highly interested in diving into United Parcel Service (NYSE:UPS).
Shares of shipping giant are currently trading for roughly $111.72, but you feel the price could push lower. Rather than set a limit price of say, $108, you could sell puts at your “limit price” and boost your income while you wait for the stock to hit your price of $108. Or, you could just simply sell puts on the stock and manage the trade if you only want to sell puts as a source of income. I prefer the latter.
If you would like to own UPS shares for $108 per share, you could sell front-month (December) options premium for at least $1.15, but realistically you could sell it in between the bid-ask spread for roughly $1.23, or $123 per contract.
(As a quick aside, typically when you have a wider bid-ask spread, you want to sell your option of choice halfway between the bid-ask spread. This alone will increase your return significantly over the long term.)
When you sell puts at the strike price of your own choosing, you get paid, which lowers your cost basis. And if your price isn’t hit at expiration, you simply sell more puts, thereby lowering your basis even further or using the premium collected as a source of income. Again, I prefer the latter.
I am always befuddled by the fact that retail investors choose not to sell puts, particularly in this situation.
You could sell one UPS December 108 put for roughly $1.23, or $123 per contact over the next 43 days. If UPS falls below your strike of $108 at expiration you would be assigned the stock at $108 share. But, in reality, you actually own the stock for $106.77 ($108 – $1.23). That’s a savings of 5.2% off the current price of $108.
It is important to remember that we can keep selling put options, thereby lowering our cost basis further, until the stock hits our stated price. If we did this over the course of a year we could sell puts on UPS approximately 12 times for a total of $14.76.
Annualized that is a 13.6% return. Of course, this is a best-case scenario, but it could lower our cost basis from $108 (where we sold the puts) to $93.24. One thing is certain: I would not buy a stock any other way.
Now you can start to see the true power of selling put options.