When I first became interested in trading and investing, I picked up a copy of Ben Graham’s Intelligent Investor. Needless to say, many years later, I still have yet to finish it.
Why? There’s nothing wrong with Graham’s style.
It’s just that there’s more effective ways for the average investor to make good returns, without having to sift through company earning reports, knowing P/E Ratios, or even be a student of Technical Analysis (although, these things certainly help).
Selling Put Options is a very easy way for both seasoned investors and beginner traders to get involved in more active trading, and boost their returns. Quite honestly, it might sound scary at first, but it is a great way to simulate purchasing stock while increasing probability of profit.
What Is A Put Option?
There’s two types of Options in the world of Finance: Calls and Puts.
Both Call and Put Options are derivatives that get their value from the underlying Stock/Futures Contract that they are derived from.
You can do 2 things with Calls and Puts, for a total of 4 different outcomes. You can buy a Call/Put, or you can sell a Call/Put. We’ll keep it to Puts for this article, but just know that whatever the outcome is with a Put Option, it’s the opposite for a Call Option.
Buying a Put gives you the right, but not the obligation, to sell Stock at a pre-agreed upon price.
Conversely, selling a Put means that you take on the obligation purchase Stock from the buyer in exchange for money.
Why Sell Put Options?
As I just alluded to, when you sell a Put Option you receive money in exchange for the possibility of having to purchase stock. You are being rewarded for the possible risk you are taking on. I should make it clear that when you sell a Put, you do not immediately carry the obligation to purchase Stock.
There are requirements that must be fulfilled, before the obligation to purchase Stock. If these requirements are not met, you get to keep the money you received by selling the Put Option while avoiding having to purchase any Stock.
The only time that you would be required to purchase Stock, as a Put Seller, would be if your Put Option goes In-The-Money (ITM) and gets exercised by the Buyer, or if it expires ITM at expiration.
For more information, you can check out this article I wrote that explores the concept of In-The-Money more in-depth.
Selling Put Options Increases Your Odds Of Profitability
Options are priced on the Distribution Curve. If you were to visualize a Distribution Curve, in the middle you would have the current price of a particular Stock. As you move to the left or the Distribution Curve, the odds that a Stock’s range exceeds a particular price (it varies by Stock and the current Implied Volatility) the odds of that outcome go down.
So in other words, we have the ability to quantify our odds of a Stock’s range over a specific period of time. This is fantastic and highly useful information, because we can then use this information to sell Options outside of a Stock’s expected move.
Here’s a brief example:
- Stock XYZ is trading at $150
- Stock XYZ has an expected 1 Standard Deviation move of ± $2
- We have a 68% chance that XYZ Stock will stay within $148 – $152
- We decide to sell a Put Option at $148
- We have an 84% chance of this Put Option expiring worthless (meaning you get to keep the money without incurring the risk)
Why an 84% probability, and not a 68% probability I hear you say? That’s because you are closing off one side of the Distribution Curve, while keeping the remaining side open. Here’s a graphic:
The Put Option that you sold just has to stay above the minus 1 Standard Deviation level. As long as it stays above minus 1 Standard Deviation, you have an 84% chance of being profitable on the trade from the outset.
Is Selling Put Options Safe?
Risk is inevitable in life. It comes in all shapes and sizes. Selling Put Options is no different. However, your risk is limited. Yes, you read that right.
When you sell a Put Option, your risk is limited to the Strike Price and Underlying Price of the Stock. If you have no clue about Options, that statement probably confused you. You can check out this guide to gain a comprehensive understanding of Options, in an easy to learn manner.
When you sell a Put Option, if you had to fulfill your obligation as the Put Seller, you would have to purchase Stock from the Option’s Buyer. Pretty straightforward stuff. Here’s some bullet points to make this easier to understand:
- You sold a Put at a $100 Strike Price
- Your Put went In-The-Money and got exercised
- You now have an obligation to buy Stock at a price of $100 per share
- Each Option controls 100 shares of Stock
- For every Put Option you sold, you would have to purchase $10,000 of Stock
- Your maximum risk is $10,000, because the lowest the Stock can go is $0
Easy enough to understand, right? Taking on $10,000 of risk might seem like a lot. However, keep in mind that this is worst case scenario. Often times, you’ll be selling Put Options that have a 70-95% chance of expiring worthless (you get all the money without the risk).
Now, for a lot of people it is not possible to risk $10,000 on a single trade. There’s an easy way around that with the use of spreads.
Selling Put Spreads For Added Protection
A Put Spread is simply buying a lower priced Put Option to cover the downside risk of a naked Short Put. For instance, if you sold a Put Option at 100, you could buy a Put at 95 to protect your downside. If the Stock moved through your 95 Put, your maximum loss would be the width of the strikes ($5 x 100 = $500), minus the credit received.
The advantage of a Put Spread is that your risk is limited to the width of the strikes, rather than the entire price of the Stock. Put Spreads also benefit from reduced margin requirements, because your risk is limited. Not only that, but they offer better returns as I’ll explain next.
What Kind Of Returns Can You Expect From Selling Put Options?
It varies on the volatility environment that the market is currently it. Returns can vary greatly if you’re actively seeking out high Implied Volatility opportunities, or if you’re using Put Spreads. The higher the premiums that you sell, obviously the more you make.
With Put Spreads, it’s possible to average about $165 in profit per $500 of risk if you know what you’re doing and what to look for. That averages out to about a 33% return on capital per trade.
The question is, do you want to make consistent returns with a high probability of profiting?