Warren Buffett famously referred to derivatives as “financial weapons of mass destruction.”
The term “derivatives” includes a wide range of instruments, including options. But if you take Buffett’s quote at face value, you’ll be missing out on a fantastic investment strategy.
Many investors equate the word “options” with high risk. But that’s wrong.
As I’ll show you, knowing how to use options the right way allows so much more versatility compared to plain old stock trading.
Selling puts is one of my favorite strategies because it’s a smarter way to make a bullish bet on a stock… especially when uncertainty is high. And put options can be a great tool for investors who want to collect income on stocks they’re willing to buy at a lower price.
My years of trading on options desks taught me three rules for selling puts the smart way. They’re the same rules I use to this day to guide my trading.
But before we get started, let’s go over a few basics you need to know before selling put options:
- Selling a put option is a bullish bet on a stock. That means you expect the stock will go higher (or at least stay where it is).
- By selling a put option, you accept the potential obligation to buy 100 shares of stock at a specific price (the strike price) at the option’s expiration date.
- When you sell a put option, you generate income (you immediately collect the “premium”—the price of the option you’re selling).
If you’re new to selling put options (or you just need a refresher), check out this post, which covers the strategy in more detail.
Or, for even more hands-on learning, check out my latest Lessons with Luke video. In it, I break down how selling a put option works, what you need to know, and why it has a great risk/reward setup.
Now, let’s go over my three rules for selling puts like a pro…
Rule No. 1: Only sell put options on stocks you want to own
While most options expire worthless (meaning the seller collects the premium and never has to do anything further)… it’s paramount to always understand your downside.
You see, selling a put option mimics buying stock. The seller collects the premium upfront… and in return, accepts the potential obligation to buy 100 shares of stock at the strike price.
Let’s look at a quick example. If you sell a $50 strike put, you’ll have a potential obligation to buy 100 shares of stock at $50. That means you’ll need to pay $5,000 (100 x $50) if the stock falls below $50 by the expiration date. That’s the key risk that a put seller needs to understand.
Put simply, when you sell a put, you’re agreeing to potentially buy a stock. So make sure it’s a stock you want to own.
That’s why when I sell puts, I focus on fundamentally superior companies with growing sales and earnings. That way, if the stock settles below the strike at expiration (and I end up owning 100 shares), I’ll have a smile on my face.
Rule No. 2: Sell put options when fear is high
Most investors cheer when stocks go up. But when the market declines, the cheer turns to fear. And fear is a major driver for put options.
As you probably know, a put option’s value goes up as the price of the underlying stock goes down.
But the price of a put option also benefits when market volatility increases. There’s a simple reason for this…
You see, put options are like insurance. When a trader buys a put, they’re protecting their long stock position from further declines.
So when the stock market hits a rough patch, buying protection gets more expensive. It makes sense. And the more volatile the market becomes… the more demand there is for put options.
Just like you don’t want to buy flood insurance on your home days before a hurricane is set to hit (it’ll be crazy expensive)… buying expensive put options during a market-wide selloff is usually a bad idea.
On the other hand, selling puts is a great way to benefit when other investors are nervous. You can collect fat premiums from fearful traders.
Rule No. 3: Sell put options on great stocks in near-term downtrends
This rule is my favorite. I always preach to buy great stocks when they go on sale.
Selling a put option is another great way to take advantage of a market-wide selloff.
That’s because when a great stock is in a downtrend, chances are it’ll bounce back once the storm clouds pass. This rule tends to work best when there’s systematic risk in the market, where all stocks fall… even the good ones.
For example, sometimes an entire sector gets unfairly punished due to a high-profile earnings miss by a major company. That event could be company specific, but the whole group gets penalized due to uncertainty… even the great ones.
I’ve seen it countless times before. Once the fear passes, the group bounces back with a vengeance. As the stocks rally, expensive puts will decline in price rapidly… generating solid gains for put sellers.
Selling a put option is a wonderful strategy, as long as you understand the risks and use the three rules outlined above. Make sure you’re happy owning the stock and make it a great one at that. That’s risk management 101.
Make smart bets that generate income on stocks you love by selling puts when they’re expensive… for example, when fear is high and market volatility ramps up. Great stocks rarely stay low for long.
Oftentimes, a near-term downtrend is a put seller’s friend.
P.S. Want more high-upside investment ideas in this tumultuous market… for the price of a cup of coffee? Try this.