Advanced Investing - Options - Part 2 - Selling Puts

Welcome.

Here's where investing starts to become a lot more fun.

This is where you start to pad your account with 'extra' money.

100 shares of a stock is called a "round lot."
200 shares would be two round lots.  300 shares, three round lots.

Round lots are really the only amount that professional investors will take a position with.

There's a reason why that is.  

Options.

Options are contracts that trade in the stock market just like regular stocks do.  

Each option contract controls 100 shares of stock.  

Well, here's a cool thing you can do that is different from the strategy of Selling Covered Calls.

It's called Selling a Put.

This is a fantastic strategy which will allow you to be paid to buy stocks at a discount.
Does that sound as good to you as it does to me!  Yes!
Obviously, that's a better way to invest - so lets Advance to Greater and start doing it.

Here's the idea behind selling a Put.

Think about a nice house on a nice street.
Imagine you live there and you like it so well that you'd like to buy the house across the street for your child to live in, and you just noticed that the house has a new FOR SALE sign out front.

Imagine walking across the street to talk to the owner and you find out that they want to sell the house for $300,000.  Now, you think to yourself, that you know the house is a nice house, and you know that you'd like to have it, but you think $300k is a bit more than you want to pay.
You think $250,000 is a good price.

(here's the magic)
So, you create a contract with the seller, but on these terms:

The seller agrees to pay you $10,000 now which you get to keep no matter what.
In exchange for that payment, you agree to buy the house for $250,000, if the seller can't sell it for more than that within two months.
After two months, the contract between you and the seller expires.

That's it.

Now think about this deal.
You have agreed to buy the house for the discounted price that you thought, ahead of time, would be a fair price.
You got paid to make that deal.
You have two months to wait to see if you get the house for the discounted price.
Either way, you have an extra $10,000 in your account!


Let's think about why the seller would agree to this.
As soon as they have that contract with you, they know that they have a minimum price that they're going to be able to sell the house for within two months.
So its like insurance for their sale of their house.  Perhaps they want that insurance because their employer is making them move by that date.  Or perhaps they're worried that the housing market will tank, right while they're trying to sell their house.
To the seller, this Put contract is an insurance policy.  One which they are happy to pay for.



This is also the basic premise behind the option strategy of Selling Puts.

There are people out there who want a little insurance for the stocks in their portfolios.
As such, they are willing to pay for that insurance.

Stocks that are very safe will have very small insurance premiums.
Stocks that are very, very risky will have much larger premiums.

When the price of a particular stock is trending higher and everyone knows its a good stock to buy, insurance premiums will be small.

When the price of a particular stock is falling and people are unsure how far it might fall, insurance premiums will be large.

The important thing is - you only sell Puts on stocks that you'd love to own, and at prices you'd be happy to pay.
If you want to get fancy, only sell Puts when the price of a stock you want is trending lower.
That way, the premium you will take in up front will be larger.


I'm using Intel in this example, because it is such a great company, with such a dominant market position.  Intel makes the computer chips that are inside most computers.  Ask yourself, will there be more computer chips in the future, or less?  More, obviously.

As of this writing, Intel is trading at $36.44 per share.  That's an okay price.  It's fair.

But we want to pay less.
Let's say we're willing to buy it for $35 per share.


So, we go over to where it says Option chain and click there.

Now, what we will see is:

First let's change the expiration date of the contract to go out a couple of months from now and look at the contract that we're interested in:

So, for selling this Put contract, we can expect to receive anywhere between $0.84 to $0.87 per share - but contracts cover 100 shares each, so its really $84 and $87 per contract in our account.

For the simplicity of this example, let's say that you were able to sell your contract for $0.86 per share ($86 per contract).

Just for being willing to buy 100 shares of Intel at a price that we'd be happy to pay ($35 per share or $3,500 per contract), and being willing to wait a couple months, we get paid!  Its awesome.

The expiration date of the contract determines what will happen to the shares after the market closes on that date.  Here's how it's figured out:

If, on November 18, 2016 Intel closes for $35.01 or more, nothing happens.   The contract simply expires and you might choose to sell another contract - again choosing a strike price that you would be happy to pay and an expiration date you prefer.

If on November 18, 2016 Intel closes at $35.00 or less, $3,500 will be withdrawn from your account over the weekend for each contract you sold and you will receive 100 shares of Intel for each contract you sold.  Your real price for those shares, though, will be $34.14    

that is $0.86 per share less than $35.

That's it, those are the only two possible outcomes.  

In one case you get paid to wait.  

In the other case you get paid to buy shares of a company you want to own at a price you are happy to pay.

Easy-peasy.  

Now, of course you can't trade stocks through Google Finance or Yahoo Finance - you have to use your own broker.

Each broker has its own way of doing things, but in my experience, its pretty darned easy to do this.
If you need help your first time, there are usually very helpful people at your broker's support center that you can reach out to for help.  Once you do it a time or two, its easy.

I'll show you how it looks in Interactive Brokers.  Other brokers will be similar.
Here's how you select the contract.

And here's what the order looks like - all you have to do is click submit.

Select Sell.

Input the desired number of contracts to trade (remember one contract covers 100 shares!)

Select which expiration date.

Select which price - I suggest putting in about what the market is trading them for (within a penny or so) 

Make sure the order type is a "Limit Order" - on Interactive Brokers that is "LMT".

Look everything over carefully to make sure its right...

then click Submit Order.

Done.

Relax.

But what's the catch?

Simple, most brokers have rules for who they will allow to sell these contracts.

For most people, you simply have to fill out a form on their website and submit it.

Then, they will approve you for either:

"Cash-covered puts" - where you have to have the full $3,500 set aside for the duration of the Put contract .... or,

"Naked puts" - where you have to set aside some portion of the $3,500 as a good faith deposit on the contract.

That's it.

Obviously, you don't want to sell contracts for more shares of Intel than you can afford to buy- 

for example, if you have a $25,000 investment account you don't want to go selling 10 contracts because those contracts would cover $35,000 worth of stock - which you might have to buy.

Avoid that uncomfortable phone call from your broker, please.

Also, keep in mind, this article is just for your education about how this idea works.  

I'm not suggesting that you should actually do this, or that you should actually execute the illustrated Put sale.  

This is just and educational exercise.  I'm not your adviser, broker, financial planner, etc.  

Do your own homework so you become comfortable with this concept.