Options traders have two enemies: time and volatility.
This is what we often hear when we first learn about this style of trading.
But, while it’s true for options buyers… it doesn’t apply to options sellers.
Rather the opposite. Options sellers benefit from the passage of time and heightened volatility.
Today, I’ll tell you why… and show you a popular method for generating income—one that could also help you time the market.
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But first, a little trip back to the basics.
An option is a financial instrument that gives its owner the right, but not the obligation, to buy or sell a security at a specific price during a specific time period (until the option contract expires).
Because options are in essence financial contracts, they always have two sides: the buyer and the seller.
Just like everywhere else, the buyer benefits when the option price is lower… and the seller benefits when the price is higher.
All else equal, the further the option is from expiration, and the more volatile the stock, the higher the option price will be.
The passage of time translates to the loss of “time value” for an options contract… making options less and less expensive until, at expiration, the time value declines to zero.
Two popular income strategies are based on options benefiting from the passage of time: selling covered calls and selling cash-secured puts.
In a future commentary, I’ll tell you more about earning income with covered calls, along with other types of options (see table below).
But today, I want to concentrate on cash-secured puts.
“Cash-secured” is both self-explanatory (you must have cash on the account to back up your trade) and confusing (puts are usually associated with a bearish outlook)
But don’t get confused here: While buying a put allows you to benefit from a stock’s decline, selling a put is a bullish strategy.
This is why you should only use cash-secured puts if you’re bullish (or moderately bullish) on the market.
When used wisely, cash-secured puts can generate some extra income and help you buy a stock at a lower price.
Here’s how it works…
The cash-secured puts method calls for selling a put option on a stock you want to buy… with a strike price set below the stock’s current price.
For example, you have cash on your account and want to own Acme, a steady business with a strong outlook.
But you feel at $100 per share, Acme is a tad too expensive. You’d be happy to own 100 shares at $90 per share, though. (One options contract = 100 shares.)
In this case, you can sell one put contract with the strike price of $90. Let’s say a contract expiring in three months is trading at $2 per share. By selling one contract, you’ll collect $200 ($2 x 100 shares) upfront—while taking on the obligation to buy Acme at the strike price of $90 if the stock declines.
By selling a put option, you can achieve two goals:
- You collect the premium—and if the stock is above the strike price at expiration, you get to keep this entire amount.
- If the stock declines to the strike price or below by expiration, it means you now own the stock. That’s because by selling a put, you promise the put buyer (the other side of the transaction) that you will buy the stock at the predetermined price. This is why you should have enough cash on hand to buy (or to be “put”) this stock.
In sum, you’ll be forced to buy Acme at $90 if the stock declines. But this is what you wanted all along—to buy this stock at a lower price.
Let’s look at possible scenarios in more detail.
- Acme drops below $90 at expiration. You’ll be assigned 100 shares at $90 per share… and you get to keep the $200. Your total cost will be $8,800 ($90 x 100 shares – $200)… vs. $10,000 three months ago.
- Acme trades above $90 at expiration. It’s not likely you’ll be assigned the stock (it ultimately depends on the stock’s path between now and expiration), but you get to keep the $200 and, if nothing has fundamentally changed, you can repeat the process and continue to collect income.
In the ideal scenario, you get to own the stock at a lower cost… and collect the premium, too—a win-win.
In time (such as in one year in the table below), this ideal scenario would give you a significant advantage over buying the stock outright.
The table also outlines other possible scenarios, and shows how they compare to simply buying the stock.
But this strategy isn’t without its risks…
Remember, nothing is really free in the market.
Selling a cash-secured put creates some income—a valuable commodity at a time of zero interest rates.
But it does so at the expense of the potential upside.
If Acme rallies to $150, you won’t get assigned the stock and won’t be able to participate in the upside. All you get to keep is the $200 premium.
This is risk number one of this strategy: opportunity loss.
And here’s risk number two: a sharp share price decline.
Let’s say Acme has been cooking the books… and the stock declines to $80 per share on the news.
Even if you no longer like the stock, you’d still be assigned the shares at the $90 strike price, giving you an immediate disadvantage and a $10 per share loss. Remember: by selling a put you took on the obligation to buy Acme at $90.
All put sellers will benefit from a simple rule: Never sell a put on a stock you don’t want to own.
Do your homework, and don’t sell a put based on a high premium. Stay conservative… and keep your price target and risks in mind.
And remember: Selling a cash-covered put is not a market hedge—it’s a strategy that allows you to take advantage of a moderate pullback in the short-term and a bull run thereafter… or to earn income if the stock marches in place.
This is a smart, conservative way to both generate income… and purchase stocks you wanted to own at a discount.
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