Selling Put Options: How to Get Paid for Being Patient
Are you thinking about selling put options but aren't sure how they work? Keep reading to learn everything you need to know about selling put options.
You don’t always have to let the market decide the price that you can pay for a stock. Instead, you can name the price that you deem appropriate to pay and wait for the stock to reach that price. Hence, this is what selling put options allows you to do.
When you sell a put option, you are selling someone else the right to sell you certain shares when the stocks reach that desired price and before a certain date. People will pay you to own a put option. Owning a put option will make them more flexible and you less flexible.
In this article, I will be discussing everything you need to know about selling put options and why it is important to be patient.
Why Should You Sell Put Options?
By selling put options, you can generate a lot more income and return, even in an overvalued and flat market. Alongside that, selling put options will give your portfolio downside protection in the event that the market crashes.
However, the main advantage of selling put options is that you can enter stocks at the price that you want. Therefore, your cost basis can be kept as low as possible. When you buy stocks during a dip, then you will get a better value for your money than what the current market price offers.
Selling put options is an underused strategy that allows you to enter equity positions at lower prices than what the market is currently offering.
Example Of Selling Put Options
Imagine you want to buy shares in a high-quality railroad company. Over the past year, they have made around $1.80 per share in earnings. Their stock is currently trading at $30.50 for every share. In addition to that, it will pay half of its earnings in dividends. In the last 10 years, earnings have grown by 7% every year, and there doesn't seem to be any catalyst that may change these trends. This company has a P/E ratio of 16 and a PEG ratio of 2.4.
The first thing you need to do is decide on a fair price for the stock. This can be done by using some kind of valuation technique or discounted cash flow analysis system. Let's assume that the fair valuation for this stock comes in at around roughly $33.20 per share.
After analysis, you decide the company is strong, and you want shares at a 10% discount to the fair value. Thus, it means a price under $30. This will give you a safety margin if the market decides to rise slower than you had anticipated. Yet at the same time, this would improve your returns as long as the growth estimates you made are accurate.
Then you could wait and see whether the price comes below $30 and buy the shares in the company. However, there is a chance that the price won’t drop to $30 and every month you wait, your money is sitting around not earning any returns.
It's smarter, instead, to sell a cash-secured put option. This way, you are assuming an obligation to buy shares in that company at a particular price and before a specific date. Also, you get paid up front for making that obligation.
Strikes And Bids
To view the current option values, you can look at an option table (generally called an "option chain") found on Yahoo Finance, Google Finance, or with your online stockbroker. When looking at these tables, the two most important columns that you should take particular interest in are the bid and strike columns.
The strike column tells you the amount of money you are agreeing to purchase the share for if your out option is exercised. While the bid column is an estimate of the amount of premium you could potentially earn when you sell your put option, there will be various options at different strike prices, and they will all pay out different bid amounts.
With that being said, put options have an expiry date. Therefore, you can look at different dates (and related options chains) to find a combination of strike price and option premium that fits your investment goals.
Selling Put Options Can Be Risky
So far, we've explored the possibility of selling put options at a strike price that is below the value of the shares in the current market. This could be a better alternative than buying shares outright, which is normally done in standard stock trading.
First of all, you are committed to a particular price that is below the current market price of the stock. Also, you will be given an option premium up front, no matter what happens to the stock or option afterwards. As a result, you are committed to an effective cost basis which is far lower than if you had purchased the shares on the open market.
However, there are some downsides to using this strategy, and the risks involved can outweigh the benefits. A lot of put selling specialists will tell you that selling put options can be quite risky, especially if you have not spent time educating yourself or you do not have enough experience with this specific strategy.
Using our previous example of the railroad company, if the company suddenly went bankrupt and the stock was going to a value of $0 per share, you would be in the same, maybe slightly worse position.
Using cash-secured puts, you will have the benefit of acquiring the shares at a lower price (compared to the one in the open market) and collecting a premium that's yours to keep no matter what happens to the stock price of the company. On the other hand, if you own the shares already and the company goes bankrupt, then you lose everything anyway, without having collected any additional premium.
One of the main criteria to minimize any risks and safely sell cash-secured puts (and for safe options and stock trading in general!) is to only focus on top-tier companies that have very little chance of going bankrupt anytime soon.
Put option selling should be about purchasing shares at a good price in a company you want to own anyway. You either get paid for waiting and committing to buy the shares at a lower price, or you are eventually assigned to purchase shares at the reduced price and still keep the option premium previously received.
Selling put options can be a powerful and flexible strategy for acquiring stocks at a discount and producing an income. Instead of purchasing shares at the price the market is offering you, you can calculate what you feel is appropriate to pay. Then you can sell that put option and get paid to wait until those shares reach that price.
You are being paid to wait until the stocks have dropped to a more reasonable price, at which you will purchase them. This is a good strategy to be used in overvalued or flat markets. You can produce a good return and keep your risks at a minimum if things don't go your way.
I hope this article was helpful in explaining everything you need to know about selling put options.
Remember that the options are financial products that carry significant risk. If you have no trading experience, you should seek out professional investment advice before putting any money at risk. Each individual investor should evaluate his or her financial situation and investment objectives before selecting an investment strategy and getting involved in options or stock trading. Potential losses in option trading can exceed the invested capital.
All the content is published and provided for informational and entertainment purposes only. None of the information contained in the content constitutes a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. You understand that the Content Creator is not advising, and will not advise you personally, concerning the nature, potential, value, or suitability of any particular security, portfolio of securities, transaction, investment strategy, or other matter. All of the information contained in the content can not be considered to be investment advice. Such information is impersonal and not tailored to the investment needs of any specific person. Make sure you have checked with your financial advisor and tax accountant to make sure you are suitable to execute what is discussed on this website.
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