Put-Option Selling: Treating the Market Like Your Own Personal Costco
by Karim Rahemtulla, Options Expert
Tuesday, June 22, 2010: Issue #1286
Did you “sell in May and go away?”
Many investors did, sending the Dow Industrials down 872 points for the month.
And although the index has put together a nice 8.1% run since the June 8 low, it’s still got a way to go before it approaches its 52-week high of 11,309, set in late April.
So what did you do while the market was selling off? And what will you do during the next one?
The answer is simple: Embrace your ugly stepchild – put-option selling! Allow me to explain…
Put-Option Selling: From Ugly Stepchild to Prom Queen
Misunderstood and often snubbed for allegedly being too complex and risky, put-option selling is like the ugly stepchild of options investing.
But no matter what mood the market is in, used correctly, put-selling can actually be your portfolio’s prom queen. It’s particularly attractive when the market is in the throes of a correction, which is exactly why I highlighted put-option selling during the market’s sell off in May.
And if you need further convincing, it’s worth knowing that savvy investors like Warren Buffett engage in put-selling without blinking an eye. Why is that? Is Buffett getting senile? Does he think he’ll lose money on the strategy?
A resounding “no” on both counts. It’s because put-selling works.
However, there’s a right way and a wrong way to execute the strategy. So make sure you understand the difference before you invest…
The Right Way and the Wrong Way to Put-Option Selling
When you sell put options on a stock, you’re obligating yourself to buy the shares at a pre-determined price (the strike price) – and a tidy discount to the current share price.
However, you’ll only be asked to fulfill that obligation if the stock closes below the strike price at options expiration. And you’ll be required to buy the applicable number of shares in relation to the number of options contracts you sold. For example, if you sell one contract, you’ll buy 100 shares… two contracts = 200 shares… three contracts = 300 shares… and so on.
For taking this obligation, you’re paid cash immediately (the option premium) that is yours to keep, regardless of the outcome. In short…
~ Put-Selling Done Right: When executed the right way, put selling is a win-win. Here’s why…
- When you sell a put option on a stock, you have a chance to buy the shares at the price you want (a discount) if the stock closes below your strike price at expiration. And who wouldn’t want to buy something at a discount?
- For implementing the trade, you receive instant cash into your account. And who wouldn’t want that, either? If that risk works in your favor, you keep the cash completely free and clear with no obligation at expiration.
- You tie up a fraction of your capital – 20% to 30% of the underlying share strike price – for the opportunity to own the shares.
- Your return on investment is magnified since you’re only tying up a fraction of your capital.
~ Put-Selling Done Wrong: If you sell puts just to “chase” the premium, you’re missing the point of the strategy. Receiving the premium is just one element of the trade. By aiming solely to grab as much premium as you can, it means you’re just trying to get money from the market and hoping the shares don’t get “put” to you because you have no intention (or no money) to buy them. A big no-no!
Four Tips for Perfect Put-Option Selling
The bottom line is that a put-selling strategy is fertile ground – especially in this market.
Here are some put-selling tips…
- The best time to sell puts is when the market is very volatile and when it’s correcting. Both usually occur concurrently. This is because volatility increases options premiums, so you receive more money during volatile periods. Plus, when the market is correcting, you can sell puts well below the current share price and still collect lots of cash.
- Only look at high-quality, blue-chip companies.
- Only sell puts at strike prices between 20% and 50% below a stock’s current price. This provides additional cushion during a downturn.
- Only sell puts on companies that you truly want to own.
If you follow these simple rules, embracing volatility with a put-selling strategy can energize any portfolio in any type of market.
Good investing,
Karim Rahemtulla
Any investment contains risk. Please see our disclaimer.
16 Responses to “Put-Option Selling: Treating the Market Like Your Own Personal Costco”
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Dubbed a "market maven" by CNBC, Karim Rahemtulla is one of the country's foremost specialists in options trading. As founder and editor of The Smart Cap Alert, he focuses his efforts on all aspects of options trading – LEAPS, put selling/covered calls and spreads. 
Examples would be helpful.
20% to 50% under the current strike price seems to yield very little premium.
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I respect and admire all you gurus and you have my gratitude for all your investing wisdom.
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Hi Not a comment but a question
When you say only sell puts during a correction, I’m wondering if that’s a correction in a down market (ie the share price is heading up that’s when you sell your put) or in a bull market when the share price is increasing. Either way at what stage of the correction should you sell the put?
Thanks
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Jennifer,
The correction we are referring to is a negative correction, when share prices are moving lower. As for when, during a correction, you sell puts… that is a difficult question since nobody knows how deep a correction might be. To counter this, what you have to decide is the price at which YOU are comfortable owning the shares regardless of where the market is or is not going. If you like stock X at the current price of $30, but would LOVE to own it at $20, then that is the strike price where you should sell your puts.
If the market is going down or in a corrective or volatile phase, the premiums received from selling puts on stock X will be substantially higher than during a period of calm. That is why it is optimal to wait for a highly volatile period when selling puts. You can measure the volatility in the market by using the VIX or Volatility Index. When the VIX is over 30, the market’s volatility is above normal, over 40, it is approaching panic levels and when it goes much higher, as it did during the market corrections in 2008/2009, then investors are fleeing stocks en-masse and put premiums are at their highest point.
You can also average into put selling by selling a few contracts at a time at different levels, following the market down. This allows you to stagger your strike prices and mitigate even more risk.
Hope this helps,
Investment U
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The article is not based on reality. I sell numerous “naked puts” each and every month. There is NO WAY you can sell a put at 20-50% under the current stock price and reap any meaningful premium on large cap stocks. Not even on BP, the posterchild for hugely volatile large cap stocks. At least not if you are selling puts only a month or so out, which is the “sweet spot”.
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Barry, do you typically sell puts much closer to the share price — 10-20%? And why is the “one month out” the sweet spot?
thanks
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June 25th, 2010 at 4.10pm.
Well, i have never heard of the Lee Lowells Instant Money Transfer. However, i do know that as a businessman man you must learn how to take measurable risk when investing and you must do it wisely.
I did a business with my knowledge and it is giving up to 50% yield over one year. Isn’t that surprising?
He who sows wisely will reap abundantly no matter where you come from. The basis of this is self determination accompanied with continious research on which ever business you are into whether farming, automobile, companies, Foreign Direct Investments (FDI), etc.
Thanks.
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I totally agree with Mr. Egan. I write put options but never for a few cents a share. 50% discount could only appear on a very long term contract. Besides getting a small premium the markets can change radically in a year.
My other criteria for writing put options is to focus on inexpensive stocks…Citigroup but not Amazon.
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E Bell, agree with Mr. Egan as well. But why focus on C vs. amazn? What is is about inexpensive stocks?
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I enjoy your comments – appreciate if you could give recent success and failure examples of good and bad trades you’ve exercised. Will you use BP as a case for Put strategy now?
Option is still viewed as a gambling method by most credible investors – it is like stepping into a casino and not knowing which table to put the money into ??? Thanks
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Hello Karim,
If you sell puts and your put options are in-the-money, is there any crime in taking the profit?
Also, how is option put-selling different from short-selling stocks?
Kenny.
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•”Only sell puts at strike prices between 20% and 50% below a stock’s current price”.
Surely you are not serious. Anywhere near the upper end of that spread will only get you peanuts,especially after brokerage fees. Not worth the bother.
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20 – 50% below current price? You could not even clear commission costs using that strategy. I challenge you to post one trade that is 50% below a current price. Maybe a two year leap? And accept all that risk for a few cents? I don’t think so.
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10 – 20% below a stock’s current price is much more realistic and will give you a reasonable premium. Remember that he strategy works for stocks that you whant to buy at a discount price.
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Coincidentally I do use the same approach. I only buy undervalued stocks that are 20% to 40% above of the 52 week price range. This stocks need to pay 2.5% dividend or higher. Stocks need to be priced between 5 and 30 dollars. I sell a minimum of 2 but no more that 10, very often about 5, put contracts about 1-2 month out, out of the money. Finally i step in to the trade when the underlining stock is oversold – just to squizze few extra cents. The key is that I want to own this stocks anyway. But most importantly i’ll like to keep my money more that i want to have the stock. If i don’t get the stock is OK , i keep my money and some change. If i get put the stock, i get the dividends, plus the stock price is discounted by the put premium and the oversold market action. At this point i am placing cover calls, but that is a topic another article. BTW 20% to 50% below stock current price is truly unrealistic, i would like to have what he is smoking.
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“I only buy undervalued stocks that are 20% to 40% above of the 52 week price range.” Correction – that are 20% to 40% above the lower price of the 52 week range. The reasoning is that the two extremeness of the range are support and resistance – everyone knows that support and resistance will be retested again so in that was i am trading a trend, besides being in familiar environments (well known 52 weeks range) lessens the probability of for catastrophic events – eider bullish or bearish in nature.
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