Buy low, sell high. This adage is the usual mantra of stock market investors, and in most cases, it works. But what if there was a way to generate a profit when a stock’s share price dips? Can you make a profit from a company’s collapse?
Market strategists have devised ways of generating income by betting against a company’s success, and many of these strategies involve put options.
Today, we’ll explain how put options work and offer insight into how to sell put options to generate additional income.
What Are Put Options?
Options are a type of contract that allows you to buy or sell a particular security, such as a stock, for a specific price by a specific date. Generally speaking, options brokers give their clients a fair amount of freedom in selecting this price and date.
The price you set is known as the “strike price,” and the date you select is known as the “expiration date.” Put options grant owners the opportunity to sell a stock at any point before the expiration date, with the strike price locked in and guaranteed.
Each option contract you buy comes in units of 100 shares. There are no limits to the number of contracts you buy, though you will pay premiums on each option contract you choose to purchase.
The premiums can vary by company and brokerage firm and are in addition to any brokerage fees.
How to Sell Put Options
Stock put options increase in value when a company’s stock performs poorly. This relationship may seem counterintuitive, as we noted in our introduction. Investors can take advantage of these dips and profit by selling put options when the stock price drops.
It may be helpful to use an example. Let’s imagine that you want to purchase a put option on the ABC company. Currently, ABC is trading at $100 per share.
You believe that ABC’s stock is about to plummet, so you purchase a put option with an expiration date three months from now.
The premium attached to this put option is $0.25 per share, so your total contract will cost you $25. You set a strike price of $75 per share.
Your next step is to monitor ABC and wait for the price to drop. When the stock price drops below the strike price, the stock is said to be “in the money.”
If ABC’s stock price should drop to $50 per share, you can purchase 100 shares from the market for $5,000.
So far, this transaction is like any other. But your put option will require the writer of your options to purchase the shares from you at the strike price.
In this example, you set a strike price of $75 per share. This rate means the writer of your option will purchase these shares from you for a total of $7,500.
By now, the math should be clear. You can determine your total profit by subtracting the money you spent ($5,000) from the money you gained ($7,500).
Your subtotal is $2,500, and once you subtract the cost of the put option itself ($25), you have a total profit of $2,475—though you may still be on the hook for some brokerage fees.
The lower a stock’s share price goes, the greater your profit margin. You can see how put options can be a simple yet effective means of generating profit from the stock market.
What if the share price never drops? This possibility is part of the risk associated with buying and selling put option contracts.
If the expiration date arrives and the stock price hasn’t dropped, the put option simply expires. As the investor, you’ll have lost the money you spent on the premium and possibly some brokerage fees, but this will be the extent of your losses.
The Risks and Rewards of Put Options
Historically, some investors have raised eyebrows at the idea of profiting from an underperforming company.
Some market analysts have recently suggested that options trading might be the underlying cause of a stock market bubble by artificially manipulating stock market prices. As with any investment strategy, there are pros and cons of selling put options.
Learning how to sell puts gives you another useful tool in your investing toolbox.
Advantages of Put Options
The greatest advantage of stock puts is that they provide a way to hedge your investments, providing a cushion for buying otherwise risky stocks.
In other words, if you invest in a particular stock, you can also purchase a put option contract so that if the company fails to perform well, you’ll be able to cut your losses and preserve some of your income.
These options are often called “protective puts” and can be a valuable strategy for risk management.
Disadvantages of Put Options
The obvious disadvantage of put options is the risk involved. Investors may never see their stock pick drop below the strike price before the expiration date.
This risk is sometimes referred to as “time decay.” If the expiration date should pass without the stock price making a good move, you will have lost the money you spent on premiums, as well as the loss of any profit you may have been expecting.
How Much Can You Make Selling Put Options?
How much can you make when you buy and sell put option contracts? There’s no definitive answer for this question since the amount you make will depend on the nature of the contract itself, as well as the volatility of the company in which you’ve invested.
Still, some investors have pursued selling puts as part of a well-rounded income, and others have tried to do so exclusively as a means of earning a living.
Selling Puts for Income
Without question, selling put options can generate some income. Selling for gain can be easier when the market is unstable, which can be lucrative when other investment strategies prove too risky.
The key question is this: How much can you earn from selling put options? The answer to this will largely depend on at least two critical factors.
First, how much are your brokerage fees? Sizeable brokerage fees—or high premiums for put options—will ultimately eat into any profits you expect to make, which can limit your ability to generate substantive profits.
Second, how large is your portfolio? Larger stock portfolios can provide greater options for investing and will allow you to absorb more risk.
For example, if you have a stock portfolio valued at $10,000, then a 100% return on that investment would only yield $10,000—and that’s if you used your whole portfolio.
Conversely, if you had a $100,000 portfolio and chose to invest only 10% of your assets, you would stand to gain $10,000 without risking nearly as much of your total asset pool.
In short, you can make profits selling puts for income, but the amount of that income will depend on your brokerage fees and the size of your portfolio. Selling put options for income might be worth the risk if you are good at picking overvalued stocks.
Selling Put Options for a Living
Selling puts for income is one thing, but can you make enough to earn a living? First, it’s important to understand what we mean by “living.”
For the sake of argument, let’s simply say that you want to earn $50,000 per year. Your mileage may vary, but we’d wager that most investors would be thrilled to make that much by investing.
How reasonable is it to earn $50,000 from selling put options?
Again, that depends on the size of your stock portfolio more than anything else. If we use the above two examples, it’s unlikely that anyone could leverage a $10,000 portfolio to produce this kind of income.
The $100,000 portfolio would be a more likely path to a steady income, though there are risks involved anytime you play with the stock market.
This disparity doesn’t mean that you couldn’t potentially start small and go big. Rather than try to earn a living from stock puts in your first year, you could set smaller goals and work toward them.
For example, you might set a goal of earning $10,000 one year, then $20,000 the next, and so on. Within five years, you’ll be making a substantial income, but only if your investment decisions pan out and the market works in your favor.
Going this route will demand thorough research and careful monitoring. Stock research websites and tools will prove to be powerful allies and, if used properly, can optimize your profits from every investment.
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