Here's Your Top 5 Option Selling Questions, Answered...
I thought I'd use this week's blog post as an opportunity to answer some very popular questions as it applies to put-option selling.
As you may know, I consider put-selling my bread 'n butter option strategy.
I talk about it more than any other.
Because it offers the highest probability to win, pure and simple.
It produces upfront cash, and an opportunity to scale into a stock of your choice at a very attractive price.
It should be a part of everyone's trading arsenal.
But of course some readers and investors won't fully understand the strategy until actually doing it.
It's the same with anything new - until you try it, you won't know how well it can work.
One of my top pieces of advice is to try it out in a paper trading (virtual) account with your broker.
I believe all brokers today offer a paper trading account. This will allow you to use fake money to test any strategy you'd like. Give it a try.
As a refresher, options trading can be done with call options and put options, or a combination of both.
I like to concentrate on put-selling because it can offer the highest probability of profit, in my opinion.
Why is that?
Well, because over time, the stock market tends to rise more than it falls. Take a look at this long-term chart of the S&P 500:
Yes, there are down periods along the way, but the picture is clear - the market goes up continually over time.
How does that help with put-selling?
Well, when you sell a put option, you are taking a neutral-to-bullish stance. So if the market goes up in the long run, then you're more than likely to make money in the long run, too.
If you've downloaded my free "Put-Selling Basics" e-book, then you are familiar with the chart below:
The circled numbers are the odds of put-option buyers losing when they bought (and held to expiration) put options during 1997-1999.
Up to 95.2% of the time, put option buyers lost money. Conversely, put option sellers were winning at that level. I know which side I want to be on.
These are some of the clearest data points that have led me to become a put-selling believer. And, it has helped my readers become wealthier in the process.
So, let's get to some of the questions.
Q: Lee, I still don't understand why someone will pay me to buy a stock cheaper than where it is now. Can you explain?
A: I get this question (in some form) more than any other.
Remember, when you sell a put option contract, someone will pay you an upfront cash payment (the premium) in exchange for your promise to buy the stock at a specified price (strike price) for a specified period of time (expiration date).
Let's say a stock is at $50 per share. You're willing to buy the stock at $35 per share.
Obviously you can't buy it today at $35 while it's trading at $50. No one will sell it to you $15 cheaper in the open market.
But by selling a $35 strike put option, you're entering into an agreement with someone that they can sell the stock to you at $35 per share if at any time the stock happens to fall below $35 between now and the expiration date.
You're giving them an insurance policy on that stock. If it falls below $35 (from $50), they can make you buy the stock at $35 even if it may be trading at $30 at the time.
In exchange for your promise, they will pay you the upfront premium - just like you pay an insurance company for your life, home & auto insurance.
Two things to note:
1. The odds of the stock falling from $50 to $35 in the time allotted is very slim, as long as you pick the right stock, the right strike price, and the right expiration date. It's not as hard as it sounds.
2. You only sell a put option on a stock in which you absolutely would love to buy at that discounted price.
If buying this stock at $35 would seem like a steal to you, then you would enter into the agreement.
Even if it fell to $30, you're still convinced that it was the right move as you're sure it will go higher in the long run.
In a sense, if you pick stocks ahead of time that you'd like to buy at a cheaper price, and you are comfortable with that potential future buy price, then put-selling may be right for you.
Once again, the reason why someone will pay you is because you're offering them an out if the stock happens to fall big time.
But as we know, moves like that are pretty rare, especially if the stocks are high quality.
Q: How do I know what strike to choose?
A: This comes down to personal preference.
As mentioned in the previous question, you need to pick a level in which you would be comfortable with potentially buying the stock.
Do you want a 10% potential discount to its current price? A 20% discount? 50% discount?
You can decide that before entering the trade. You can also look at the stock chart and see where support lies. That's what I do.
Once the strike is chosen, then see how much it's paying out at different expiration dates.
The longer the expiration date, the more money you'll receive upfront.
The choice is yours.
Q: What happens if I have to buy the stock? How do I get the shares?
A: If the stock actually falls far enough and ends up at a price which is lower than the strike price (i.e. - below $35 like in the example above), then you will be "put" the shares at $35 and have to pay for them in full at that time. Your broker will handle the transactions automatically for you.
Remember, one option contract is the equivalent to 100 shares, so only trade the amount of contracts that equate to the amount of shares you'd like to potentially buy.
Q: Can I get out of the trade if I don't like the stock anymore?
A: Absolutely! The great thing about options trading is that you don't need to hold it until expiration. Just like a stock, you can get in and out at anytime you wish.
Now, option prices fluctuate higher and lower just like stock prices, so if you want to get out, you may have to buy the put option back at a higher price than what it was originally sold for.
When selling options, the sale comes first, and the buy transaction occurs second. Sell first, buy second - in that order.
So if the option was originally sold for $1 per contract, and it was later worth $1.25 per contract when you needed to buy it back, then it would lock in a loss of $.25 per contract.
That equals a $25 loss for each contract traded.
Once the option is bought back, the position is closed and will disappear from your trading account. Your obligation to potentially buy the stock in the future no longer exists.
On the flipside, if the option loses value over time, then that's a good thing.
Because it can be closed out and bought back for a profit.
Let's say the option was sold for $1 per contract, and then over time, it became only worth $.20 per contract.
That would be an $.80 ($80) gain for each option contract traded.
The option could be bought back for $.20 and the trade would now be closed.
We use my "80% Rule" to take profits on options that we sell.
Once an option that we sold has lost 80% of its value (like the example above), we would buy it back and lock in the gain. At that point, the trade would be over and we'd move onto the next one.
Q: What kind of account do I need to sell put options?
A: Selling put options can be done in any kind of account, but it is my preference to use a "margin" account for it.
Since it is not known ahead of time whether you will end up buying the stock at expiration, it should not be necessary to have to put up all the cash to pay for the stock. Sound logical?
But, if you sell put options in a "cash" or IRA account, you are required to have the cash in your account to cover the full purchase price.
If using a "margin" account, your broker will only require you to have roughly 20% of the full purchase cost on hand in cash. This is a much better use of funds.
For instance, if you sold a $50 strike put option, it would equate to an outlay of $5,000 at expiration if you were "put" the stock.
If the option was traded in a cash account or IRA, you would need that $5,000 available at all times, even if it looked unlikely that you'd end up buying the stock.
In contrast, if it was transacted in a margin account, you'd only need an initial $1,000 cash on hand to make the trade (20% x $5,000). A much better system.
The $1,000 cash hold is called the "margin requirement".
Don't confuse it with "trading on margin" which entails borrowing money from your broker to buy shares of stock. They are two completely different concepts, even though they both have the word "margin" in its title.
Those are the top five questions I typically receive when teaching readers about put-option selling.
If you want to see even more questions, head over to our FAQ page for a larger list.
What's your question? Send them to me and I'll be more than happy to try to answer (no individual investment questions please!)
Until next time...