As a professional options trader for roughly 20 years, I have discovered that most options strategies are best within certain types of market environments. However, this strategy – known as a favorite among options professionals – works well in any market environment: bullish, bearish or neutral. So, what is the strategy to generate income without owning shares? Selling puts, or put option selling. The semantics don’t really matter.
Selling puts is the best way to obtain the stock you have been eyeing for a much lower price than where it’s currently trading.
When a stock price is inflated, most investors enter a limit order to buy the asset at a lower price. Yes, they sit and wait and wait . . . and wait so me more. In most cases this goes on for months with nothing happening other than lost opportunity costs. In fact, it’s been shown that more than 99% of all investors do it this way.
But by selling puts on a stock that you wish to hold in your portfolio, you could be collecting income, thereby lowering the cost basis of the stock even further. We’ve been doing just that in our High Yield Trader portfolio for big gains. I’ll get to that in a second.
Selling a put option means that you are obligated to buy the 100 shares at the strike price if the buyer so chooses prior to the expiration date. This, of course, won’t happen until the stock price drops below the strike price.
This is where you — the put option seller — come in. Since you want to own the shares (albeit at a lower price), you sell a put option and just wait until options expiration. If the stock closes above your chosen price (the strike price), the put expires worthless and you get to keep the entire premium collected at the outset.
If the asset closes below the strike price, you will be put (assigned) the stock that you wanted. In other words, you will be obligated to buy the shares at the “strike price.”
Just think how much you could reduce your cost basis if you did this for months. Everyone knows you’re supposed to buy low and sell high. This advice is so common and so basic. And yet, almost no one talks about how to buy low – let alone how to sell high.
Today I’d like to discuss an ideal setup for selling puts. Let’s say you’ve been watching General Mills (GIS) for the past few, but you’re not quite interested at the current price of $53.28. You prefer to pay $52.50.
Now I know that some of you could care less about GIS, but it’s more about the strategy. It’s more about learning the mechanics of selling puts to reap steady income or to simply lower the cost basis of a stock you wish to own in your portfolio. I chose GIS because it is in an oversold state, which is an ideal time to sell puts on a conservative, low-beta, blue-chip stock.
By selling the August 52.5 puts you can bring in approximately $0.85, or $85 per contract. In this instance, you are selling the put with the intent of buying GIS for $52.50 if, at expiration in roughly 36 days, the stock is trading at or below $52.50.Selling the August 52.5 put requires you to have $5,250 of cash in your trading account.
If not cash-secured, selling puts only require 20% of the $5,250 or $1,050, but retirement accounts and certain brokers require the puts to be cash-secured. And in this case, that would be the $5,250.
The return on the trade is 1.6% in roughly 36 days, or 16.0% annually.
This lines up exactly with my goal of bringing in between 1% and 3% selling puts each month.
And if the puts were not cash-secured, the return would be significantly higher.
If the stock closes at August expiration above $52.50, we keep the $85 and oftentimes repeat the process by selling more puts, maybe at the 52.50 strike or possibly at a different strike price. It truly depends on where the stock is trading at the time we sell the puts and how much premium we wish to bring in.
If the stock trades for less than $52.50 at August expiration we are assigned the stock for $52.50 per contract or $5,250 (100 shares per put contract sold). Oftentimes when this occurs I will begin to sell covered calls on the stock so there is an ongoing source of income coming in. I take this approach in one of my High Yield Trader portfolios, appropriately named “The Income Cycle.”
Speaking of High Yield Trader, Ian Wyatt and I will be hosting a live teleforum on Wednesday, July 19 at 2 p.m. ET.
During this live event, we are going to discuss our strategy for selling puts on Warren Buffett’s top 15 holdings.