In the past I’ve told you about covered call writing — a conservative strategy using options that can generate substantial income. And today, I want to discuss what might be considered the mirror image of covered call writing — put writing.
Like covered calls, this approach is fairly conservative as long as you follow a few simple rules. More on that in a moment.
First, let’s summarize what put selling is all about.
Essentially, what you’re doing is selling insurance to other investors. And you get to control ALL the variables — the particular investment being covered by this insurance, how long the insurance contract is good for, and even how much you’ll accept to issue the “policy.”
This insurance is issued in the form of put options contracts, which give investors the right to sell set amounts of a stock or ETF at a particular price (the strike price) during a particular window of time.
Here a few things you need to know:
- One options contract covers a “round lot” of the underlying investment — which means 100 shares.
- Options on U.S.-listed contracts expire on the Saturday following the third Friday of a given month, unless that Friday is a market holiday. In the latter case, they expire on the Friday.
- To buy or sell options contracts, you will need to get clearance from your brokerage. However, writing options requires the most basic level of clearance, and you should simply need to fill out a quick form.
I recommend writing puts as a way to collect upfront income and target high-quality investments you’d want to own anyway …
Let’s say you like XYZ dividend stock that’s currently trading at $16 but you’d like to buy on a dip, when it hits $15.
Well, instead of just waiting around for a pullback — which is what almost all other investors do — you can sell a put option instead.
In this case, you’d be selling someone else the right to sell you 100 shares of their XYZ at $15. And again, you could determine how long this right was good for — maybe a contract length of two months or so.
Once you’ve sorted out those details, you just place this order with your broker like you do any other trade. It really is just as easy, in fact.
Then, after someone agrees to buy this insurance from you, you’ll immediately collect your premium — the money they paid to buy the insurance from you.
It could amount to hundreds or even thousands of dollars depending on a number of factors.
That cash is yours to keep no matter what happens next. So immediately, you’ve already made some money!
And in all but one scenario you end up keeping that money with no other obligation.
Better yet, you’re free to do whatever you want next — including writing ANOTHER contract and collecting MORE cash upfront!
What about that other scenario — the one where you don’t just keep your insurance premium and move on?
Well, let’s stick with our example and say XYZ goes down to $15 (or below) and the other person decides to actually use the insurance.
That last part is a critical distinction because like I said a minute ago, only one out of ten people end up actually using their insurance.
Anyway, in this case, you will have to buy the shares of XYZ at $15 like you agreed to do.
Please note that this is the only price you can be asked to pay — never a penny more or less.
And as long as you have the money in your brokerage account to pay for the shares — which is always what I recommend — then you’ve actually still essentially “won” with this strategy.
The reason is pretty obvious: You ended up owning an investment you wanted to buy at the price you wanted to pay.
More than that, you actually bought it at a LOWER price than you wanted to pay since you also collected that premium upfront.
The only key here is that you must be ready to take ownership of the underlying stock, too!
There are just a few other things to note:
First, you could start off with an immediate paper loss when you take possession of your shares if they’ve fallen below the strike price of the contract you wrote.
Second, those losses could be substantial if the price implodes.
Third, as I mentioned earlier, you should have enough cash in your brokerage account to cover the potential stock purchase under the put contract.
Yes, it IS possible to write puts on margin — meaning you DO NOT have enough cash to cover the trade. But I don’t recommend going that route because it could result in losing other positions in your brokerage account or owing money that you don’t actually have in the event that your put contract is exercised.
But the bottom line is that once you get comfortable writing put options, it’s quite likely you’ll never end up just waiting for a pullback or entering limit orders on investments you want to buy.
Instead, you’ll happily start getting paid to wait — which is the very cornerstone of smart income investing!
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