Using a Put Selling Strategy: A Step-By-Step Lesson On Selling Options
by Lee Lowell, Stock and Commodity Analyst
Monday, June 29, 2009: Issue #1029
Let’s say you’ve been interested in buying Microsoft stock and you feel $20 is a good price to pick up some shares. It currently trades at $23.50 per share, so you’ll need it to fall in price a bit before getting filled on the trade.
Most stock traders would just put in a “limit buy” order to buy the stock if/when Microsoft falls down to $20 per share. But there’s no guarantee that Microsoft will ever fall to $20 per share, and there’s no one paying this stock trader upfront for his time while they wait to buy Microsoft at $20…
That is unless you’re using a put selling strategy…
As an option trader, you can take the transaction one step further by selling a Microsoft $20 put option contract – you’ll receive the going rate for that option and receive instant income.
I recently showed Investment U readers some of the ins and outs of put options – you can read all about them, but right now I’m going to show you how to profit from a real life example of selling puts options.
Selling Naked Put Options – Strike Prices & Option Chains
When selling naked put options, it can be hard to grasp how the strike prices and contract prices work together until you understand what an option price list – or option chain – looks like.
Take a look at Microsoft’s option chain below:
Chart: http://www.investmentu.com/images/iu062909chart.gif
This is a typical option chain for Microsoft options that expire in January 2010.
- The strike prices are listed in the column in black. Since we’re interested in the $20 strike price, we look at the JAN10 20.00 line.
- Scan over to the “bid” column that shows how much you can receive for selling that $20 put option contract. The bid column shows $1.30 as the price. This translates into $130 you will receive for every $20 put option contract you sell because all prices are in listed in per share costs. And an option contract controls 100 shares of stock.
- For a typical 1,000 share stock trade, you can sell 10 put option contracts and instantly receive $1,300 in your account, no questions asked.
This is money for you to use anyway you see fit. No matter what happens, this money is yours.
In exchange for selling those 10 put option contracts and receiving your instant $1,300, you are obligating yourself to buy 1,000 shares of Microsoft at a price of $20 per share until the expiration day in January 2010.
At this point, you know ahead of time that you will be obligating yourself to buy 1,000 shares of Microsoft at $20 per share, for a total investment of $20,000.
Not only do you get to collect $1300 upfront just for placing the option trade, but you’re also giving yourself a chance to buy a stock that you want to own, at the price you want.
How great is that?
As long as you know this potential future transaction is within your financial means and trading plan, then it is a win-win situation for you.
When Selling Options, What Happens On Options Expiration Day?
So, when selling put options or any options, people often ask what happens when options reach their expiration date?
Only two things can occur at expiration – either the price of the stock is above the chosen strike price or it’s below.
- If the stock finishes above the strike price, then the trade is over and the option expires worthless. The option buyer walks away with nothing while the option seller gets to keep the upfront cash with no further obligations.
- If the stock finishes below the strike price at option expiration, the option buyer will “exercise” his right to the contract and you will be required to fulfill your end of the agreement – which means you end up having to buy a stock you wanted at the price you wanted.
Sounds pretty good to me. And all the while you still get to keep the upfront cash.
So in the case of our Microsoft example above…
- If Microsoft closes below $20 in January 2010, you will be obligated to purchase your 1,000 shares at $20 each. With the $130 received upfront for each option contract, this essentially reduces your cost basis to $18.70 per share once the transaction is complete. Not bad.
- If Microsoft closes above $20 at January 2010 expiration, the trade is over and the option expires worthless. You keep the $1,300 and are free to repeat the process again for another expiration period. This is the key to income generation.
As I mentioned in my article about selling naked put options article that up to 90% of option contracts will expire worthless, leaving you with the upfront cash payment.
After implementing this strategy for a while, you will come to see that most of the trades will expire and you’ll keep padding your account with instant income.
Using a Put Selling Strategy – Six Tips to Selling Options
A few guidelines to keep in mind when selling naked put options:
- Only sell put options on stocks you want to own. Do not use this options trading strategy on high flyers just to receive the upfront income.
- Only sell enough contracts to stay within your comfort zone. If you normally trade in 500-share blocks, then only sell five option contracts.
- If you are uncomfortable at anytime during the trade, or do not wish to own the stock at the strike price you’ve chosen, then you can unwind the trade at any point. All you have to do is buy back the put options you’ve sold.
- The option price will fluctuate during the course of the trade. It may get cheaper or more expensive while you hold it. The bottom line is – you’ll either get to buy the stock at expiration or the option will expire with no value.
- You will need to have an approved “option trading account” with your broker. This needs to be set up before making these transactions.
- You’ll always know ahead of time what your potential total outlay will be if obligated to buy the shares. No surprise endings.
That’s all there is to selling put options. It’s easy, simple and much safer than most investors imagine if you just stick to my six tips above.
Good investing,
Lee Lowell
Related Investment U Articles:
- Put-Option Selling: Treating the Market Like Your Own Personal Costco
- How to Sell Put Options and Snag the Market’s Daily Deals
- How to Recover When Your Option Trades Turn Against You
- The Covered Call Strategy: Generating Income From Stocks in Any Portfolio
- How to Buy Gold for $100… And Get $200 Back
17 Responses to “Using a Put Selling Strategy: A Step-By-Step Lesson On Selling Options”
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Along with Karim, Lee is one of America's leading options professionals. Over the course of a distinguished career, which includes six years in the options "trenches" as a market maker on the floor of the New York Mercantile Exchange (NYMEX), he has developed a proprietary trading method capable of enormous upside while actually reducing risk. 
One other advantage is that puts can be moved out up or down in price as conditions warrant.
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Not all of them expired worthless, remember GE a while ago? I ended up having to buy the stock, fortunately the stock went up and I made a small profit.
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Thank you so much for writing this! I have traded calls but have made a hard time making the “leap” to puts. Thank you for using an actual scenario to help us understand this concept better.
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My discount online broker does not allow selling naked puts. What are some other companies that will allow this?
Thanks
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Use a covered call strategy instead. Buy the stock (in blocks of at least 100 shares) and sell equivalent call options (1 option for every 100 shares) at the same strike price you would have sold your naked put. You will see that these two strategies are nearly identical.
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pl explain the byer side story too.He is the one who pays upfront money? How does he benefit?
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great job. i have always had trouble getting my, brain wrapped around puts; you’ve helped no end. question:do dividends have any impact on a transaction of this nature? d l hutchins i think not but would like your response to this.
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You explained it concisely, easy to understand.I am selling covered calls for a long time and kicking myself for not using your straregy before. Now I only have to make sure I keeep enough cash to buy the stock if i have to.I am sure it will work well.
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Is there anything other put besides a ‘naked put’? I am confused by the names.
If you sell a put, you probably don’t have the stock already. So aren’t all puts ‘naked’?
Thanks for your reply.
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Great info…selling increases profitability over buying as there is a 2 out of 3 chance to make money…as opposed to buying which has only a 1 out of 3 chance to be profitable.
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Thank you for the clarity on the nuts & bolts of the naked put! What is the median life span [purchase/execute to expiration] of these trades as prescribed by the Instant Money Trader?
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I think a “covered” put would be writing a put on shorted shares.
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Great job! I only sell puts on ETFS and some stocks I like to own cheaper. You mentioned in you writing above that repeat this monthly. I sell mostly puts expiring in 9 to 12 months on margin 10 to 15% below stocks market prices. Generally I collect 10 to 11% premium a year but because of margin I make 20 to 25%. I want to collect more money. Is selling puts on long expiry dates give more premium than with 1 or 3 months expiry. Make sure you consider broker’s commissions when you calculate net annual percentage of premium collected. Waiting for your reply. Thaks very much.
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One thing to keep in mind when selling puts is that if the stock price drops and you are obligated to buy the stock, you can then turn around and start writing covered calls on those shares. So you will have a stock that you want at the price you wanted it for and begin receiving income for owning it. And if your call option is exercised, you’re selling at a profit and can start over again.
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Selling naked options, either calls or puts comes with substantial downside risk that is not well explained in this article. What happens if catastrophy strikes and MSFT shares plummet to $10.00? Well, the seller of that $20 put is obligated to buy shares at $20.00 when they are only worth $10! How great is that?
Have you ever seen the price of a stock crash after bad news is released?
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“Have you ever seen the price of a stock crash after bad news is released?”
There is definitely risk involved with naked puts and one should stay away from this type of trade around earnings season.
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When a selling a naked put, what net premium you receive. Is the net premium,- the value you receive at the time of selling put minus or plus the fluctuated (as option price go up and down during the life of the option) price of the option, or you keep the whole premium if it expires out of money.
I also see that my broker has not credited the amount in selling the put in my account – is that right?
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