In a previous article I discussed how selling put options is a viable alternative to owning stocks. It provides income from the premium that is collected and the strategy doesn’t tie up as much cash as holding common stocks. Please go back and re-read the article. I also recommend purchasing and reading a wonderful book that provides lengthy details on how to make this strategy work. At the bottom of this article is a direct link to the book, available on Amazon. The link is “Selling Puts for Income” and the book is “The Options Machine.” The link is provided directly below, at bottom of page.
A delightful reader and follower of my blog, “Linda” asked me to explain how I mitigate risk when I execute this strategy. She is a pre-retiree like myself and is interested in this strategy, but at the same time she is very risk-averse (like me! I share Linda’s sentiment in trading). I will try to explain my strategy by reviewing my steps:
- I like to target the common stocks of solid, liquid, dividend-paying companies that are down on the day due to headline risk, a short term phenomena. An example of this would be IBM, JNJ, PG, or MSFT. Anyone would agree these are solid companies, their stock is liquid and they’re not going anywhere, they’ll likely be in business for the remainder of our lives. These are the type of stocks I target. As you are aware, I’m a fitness fanatic and I am working out in my home gym each morning and my TV is set to CNBC. This allows me to catch up on headline news, earnings reports, etc. When a solid company misses earnings by a penny and drops 7% in pre-market, there’s a good chance I’ll be targeting that company for put selling Over the past two years I’ve done this over two dozen times. Examples are: AAPL, MCD, MDT, K, KMB, PM and MO just to name a few. Each and every one of these examples made money for me. Not a single loser.
- The options expiration is usually 2-4 months out in time, sometimes up to 6 months depending on liquidity and the amount of option premium I am able to capture. The strike price is between 5-10% below the opening price. Here’s is a hypothetical example: CNBC captures my attention as Amgen beats earnings but revenue is light (or vice versa), the stock is down 8% in pre-market trading and is trading at $186/share, down from $200 the previous day. The stock opens at 185.25. I will scan the option chain for options trading near a strike price between 165 and 175 per share. I discover I can sell the October 170 puts for $4.50. These are what I judge to be far enough out of the money and this is far enough out in time to allow the stock to recover.
- I place a limit order for 3 contracts of the October 170 puts for 4.50 (or $450 per contract) and the order fills. I have now collected $1350. in total premium. What’s the risk? The risk is that Amgen stock closes below 170 at the October option expiration. If it does I’ll be obligated to purchase 300 shares of AMGN at 170/share. HOWEVER, since I collected $4.50 per contract, my actual cost basis for the AMGN purchase would be 165.50! Now do you see why I love this strategy? There are risks involved and you MUST have cash available by the time option expiration rolls around; but it’s far less risky than owning the common stock outright, in my opinion. Keep in mind that this is a hypothetical example, but it’s an example of how I implement this strategy. It’s certainly not for everyone but I’ve used it with great success.
- Another thing to consider is that you are under no obligation to hold the options thru option expiration. Many times I will buy the option back and close the trade out early. In this example, let’s say that by mid-September AMGN has recovered nicely and is back to trading at $195/share. The put options that I sold are now worth only .80 each. I decide to close the position and take a nice profit. I place an order to “buy to close” the 3 contracts for .80. How much have I profited? $1110.
- ($1350 premium collected minus the premium remaining of $240. equals $1110. (or $4.50 – .80 = $3.70 x 3 contracts or $1110 total profit). NOTE: Commissions are not factored into any of the above examples
- How do I control risk using this strategy? For of all, re-read #1, I target solid companies down on short term news events only, not the Tesla’s or Herbalife’s of the world. I choose strike prices far enough out of the money that provide me a nice downside cushion. I give myself enough time for the stock to recover. I also am greedy when it comes to premium. I have to be offered enough premium to make it worth my time and effort. This usually comes from higher priced stocks. Don’t try this with GE or AT&T stock. Those stock prices are too low fort this to work. At a minimum you need a $40 or 45 share price. 70 or 100 is better.
I hope this provides a reasonable explanation of how profitable and less risky these trades can be. If you have any questions feel free to write them in the comment section below.
DISCLAIMER: THIS IS NOT ADVICE! I am not an investment advisor, nor a professional in the financial services industry. Options trading and stock market investment do have risks. This blog is for informational purposes only and the reader is 100% risk responsible for any and all trades and investments made.