In this article, I will like to discuss selling put options to achieve higher returns. Do note that using options is a high risk tool and it can lead to losses.
You dictate the price you want to pay for a company’s share price which you would like to own and you get paid while waiting for the price to drop to that exact level. This is selling put option. When you sell a put option on the stock, you are selling your “counter party” the right to make you buy 100 shares at a certain share price (this is known as “strike price”) before a certain date (known as “expiration date”). I use “counter party” in this context but it is similar to buying shares, there is a bidder and a seller. There is always someone on the other side to do the trade. The counter party will pay you for this option to increase their flexibility while you are been paid to reduce your flexibility (been inconvenienced).
The risk is apparent and seen in my most recent experience, you can read it here. I was waiting for RDS.B to drop to USD 55 per share. While waiting, I sell put on RDS.B. A black swan event comes and the share price drops to USD 51 at the expiry date, the option is exercised. I was assigned 1000 shares of RDS.B at USD 55. I was paid a premium while waiting. However, I could have bought RDS.B at a lower price of USD 51 instead of USD 55. When the share price drops below USD 55, if you close the option, you will suffer immediate losses of price difference x quantity of option. The premium is the money paid to you while you are waiting for the option to expire. If the option expire without exercising, meaning if the share price of RDS.B is USD 58 at expiry date while sell put @ USD 55, then it is worthless. I keep the premium and I do not get to buy the shares.
Advantages of selling put options
Selling put option can serve as an income generating method in a flat or overvalued market. First, you need to determine the intrinsic value of the company. Next, you need to determine the margin of safety. This will help you to dictate the price you want to buy the company for. Then, you sell a put option and get paid while waiting for the right share price. You can determine the price you want to purchase at and get it at an even lower price. For example, if a company’s share price is USD 25 and the premium is USD 1 per option. You pocket USD 1 x 1 option (100) = USD 100 while you sell put. Say this option is exercised, you are buying the shares at USD 25 – USD 1 = USD 24.
Options Terminology in Sell Put
Strike – This is the strike price that you are obligated to buy the shares if option buyer exercise their option to assign them to you.
Price – This is the price that option is selling for.
Bid – This is what you will receive in option premiums per share if you sell put.
Ask – This is what option buyer will pay the market maker to get option from him. The difference between bid and ask is the profit the market maker is making.
Volume – This is number of option contracts sold.
Open Interest – This is number of existing options for this strike price and expiration. All option volume less option positions closed.
There is a limited rate of return and the said risk is huge. For example, if the company were to go bankrupt and drop to $0, you would be forced to purchase at the sell put price. That’s why it is important to do your homework first before you sell put to collect premium. Sell put only on high quality companies to reduce your downside risk.
Selling put options can provide additional returns to your portfolio while waiting to enter a position. This strategy is ideal for flat or overvalue market and build downside buffer for your portfolio position.