We've written about the allure of making money selling covered call options. Honestly, this is how I make half my income. However, there is another derivative I prefer even more. That would be selling put options. Many investors, including myself, prefer selling puts over selling calls, because there's even less risk and more profitability. This strategy offers great benefits albeit with risks, which we'll dig into with this article.
What Is A Cash Secured Put Option?
Like a call option, a put option is a financial market derivative instrument which gives the holder the right to sell an asset, at a specified price, by a specified date to the writer of the put. The purchase of this put option signifies a negative sentiment about the future value of the underlying stock. When you sell a put option, it signifies a positive sentiment about the future value of the underlying stock.
Selling a cash-secured put involves selling an at-the-money or out-of-the-money put option, while simultaneously setting aside enough cash to buy the stock should it fall below the strike price. Besides collecting premiums, put sellers also may acquire the stock below the current market price if the option is exercised.
You see, unlike with an outright stock sale-and-purchase transaction, this seller is only really on the hook if the shares exercise. That's why it's called a "cash secured put." If the stock doesn't go down, you don't have to give anything away and you simply collect the premium the buyer paid for the option.
So Why Sell Cash Secured Puts?
Selling a cash secured put is a bet that the underlying stock will rise in value. The premium amount is guaranteed and is yours regardless of what happens. Making money selling cash secured puts can be very profitable for those willing to take some relatively small risks. There are two ways to be profitable here: long-term or short-term gains. Let's dig into each one.
1) Long-term Gains. The seller receives a guaranteed income regardless of what happens with the stock. If the stock rises you're making money, and if it falls you're still making money. However, you would have to make that money back over time because the cash flow has to cover the obligations as well as the actual cash received from selling those shares in case of exercise, or giving them away for free. Given that this is an option rather than a physical security, you'll have to pay taxes on your gains when those shares are sold or given away.
Let's say for example that you receive $300 in premium per contract, and you sell 10 of these contracts (each contract is always 100 shares) worth $10 each share. You've already made a guaranteed income of $3000 ($300 x10), but now must pay taxes on that amount each year plus whatever interest may be paid by your broker on top of that if anything is left over after paying broker commissions and such (it's typically 1% annually). Let's say it all comes out to 1% in total annual expenses. That $3000 has turned into about $25,640/year, which is rather excellent.
2. Short-term Gains. In this case you short the stock and sell options against that short position on a day-by-day basis. If you want premium income every day without locking yourself into any one specific risk profile for years at a time. This is more risky than just selling calls or puts outright because if the underlying stock moves against your position too much (and there's always going to be some movement) your broker will require margin calls--in other words they're going to ask you for more cash and force liquidation of your position so that they get their money back.
In this case you're speculating on the short term movements of the stock and thus your broker may not allow you to keep as much of your gains. For each contract written, you'll need to provide 15-20% in margin for that one contract in case of a margin call (in other words, if the stock goes down by more than 20%, they will force you to liquidate). If not, you can keep the rest for yourself. You may need additional money to hold if you want to write more contracts on the same stock within a short period of time since margin rates can change daily based upon market conditions and broker rules.
This technique is an excellent way for those with limited amounts of capital but who have some cash flow on hand from a job or business or any other revenue source that generates cash on a monthly basis. It's also fantastic for day traders who are willing to roll over their contracts from one day to another and hope that increasing trading volume increases their profit margins. The underlying security doesn't have to be a volatile one; some of the best are stocks whose prices can move up or down by 2% or more in a single day.
What Are The Best Stocks To Sell Puts With?
S&P 500 stocks are still the most popular and ideal candidates for writing (selling) puts. They're generally safe enough to prevent margin calls but volatile enough to see a few double-digit percentage swings per year, which really drives those premium rates through the roof. A high price-earnings ratio stock is what you want because you'll have more capital behind your selling activities with higher price contracts, but a lot of the same fundamentals apply here as they would with selling call options. S&P 500 companies will generally be safer because they typically tend to pay dividends and sometimes those dividends rise over time. Remember, you're mostly making money by the premium, not the spot price of the stock.
You can also write puts against ETFs that track larger cap stocks like Vanguard's VOO or iShares' VOOGL or DIA. This will give you more diversification across multiple companies rather than just focusing on one company's prospects (however these funds are usually not as profitable as selling individual stock options).
What are the Benefits of Selling Puts?
The cash securitization of options gives a seller a huge advantage over exercising their actual shares. Effectively a cash secured put is like printing money without the actual creation of currency- you're just printing option contracts that have an inherent value but they can't be cashed out in case of trouble. You also don't have to split your gains with the IRS every year because it's already been taken care of in your contract with the buyer. That's why you should sell puts rather than calls if you want to find some good stable income over long periods of time; put premiums are generally higher than call premiums and thus result in more profit.
What Are The Risks of Selling Puts?
If too many people try to sell puts on the same stock it can result in a "put spread" which is when multiple contracts are being written at once with everyone trying to sell calls or puts against the same underlying security, often resulting in very volatile prices. In other cases, the price of the underlying stock can fall before your contract expires, and you may not have enough cash to cover it without losing your margin.
Profitable and Passive
Cash secured puts are always going to be one of the most profitable investments because they don't require you to sell or purchase anything. As long as the buyer is willing to pay for that contract, then you've got an income stream and a passive-risk profile that won't force you to sell out no matter how big (or small) your gains are. Cash secured puts are great when long-term investment is needed but there's not enough capital for outright purchases of whole shares, especially when it comes from multiple sources of income like retirement funds or business ventures. The key with this method is patience and not trying to time the market too much.
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