The following article originally appeared on DivGro on Jul 14 2017. Big thx to Ferdis to start a guest post series on options!
If you’re a dividend growth investor, you buy a stock and capture the dividend for reinvestment. Did you know that selling puts could boost your income? Yes, there are horror stories about options. But selling puts is useful if done wisely.A short introduction to selling puts
When you sell a put option it is a contract between you and the market. Yes, the market! You will never know who bought the put from you. The contract has some specific elements:
- An underlying: the stock that is used as a reference
- A strike price: the price at which a transaction could take place
- An expiration date: the date until which the contract is valid – the day after, it becomes void
- A premium: the amount of money the buyer has to pay to the seller.
As the seller of a put option, you have the obligation to buy the underlying at the strike price. You have no control over this process and the option can be assigned at any time. But you get to keep the premium, whether the option is assigned or not!
Assignment should only happen when the stock trades below the strike price.
Why? When the stock trades above the strike price, the owner of the put will make more money by selling the stock at the market price, rather than selling it to you at the strike price of the contract. Imagine you sold a put option at a strike price of $50 and the stock now trades at $52. Why would the owner of the put option sell the underlying to you at $50 when the market is willing to pay $52?
Why sell puts?
The simple answer is to collect the premium!
If you sell a put option and the stock price remains above the strike price, you get to keep the premium and your obligation goes away the day after the expiration date. With no further obligation, you can sell another option and repeat the cycle.
Collecting premiums can become an important source of income. In fact, it could be a monthly income source!
Sounds too good to be true!
Clearly, selling puts is not a risk free Wheel of Fortune.
The stock price could go below the strike price. If that happens, the option holder could exercise the option and you would have to buy the stock at the strike price.
If the stock price drops well below the strike price, that would be a big bummer! Consider the above example again. If the strike price is $50 and the stock trades at $45, you’re obliged to buy the underlying at $50 if the option is assigned. That would not make you happy, because you’ll have an instant (unrealized) $5 loss!
In that case, no thanks…
If you’re a dividend growth investor and you do your homework, you know what price you would be willing to pay for a stock on your watchlist. Normally, you’ll watch the markets and wait for the stock price to drop to your entry level. In the meantime, your money would sit in your trading account, earning nothing!
With options, though, you could sell a put option at a strike price near your preferred entry price and earn a premium while doing so. Now the cash in your trading account is used as collateral for the put option and it produces a yield! (Your broker will block an amount of money to cover your obligation).
In essence, you get paid while waiting for the stock price to reach your preferred entry price!
That makes sense!
With a put option, you’re not guaranteed to get the stock at the strike price. The stock price may not fall below the strike price before the expiration date. Or, the stock price could fall below the strike price but then bounce back above the strike price before being assigned. In contrast, a limit order at your preferred entry price will get executed as soon as the stock price goes below the limit price. But you don’t get paid for limit orders. You can’t have it all!
Selling put options is not as dangerous as people claim it to be. Losses are not unlimited. When you buy a stock, the theoretical loss is the price you paid for the stock, assuming the stock price drops to $0. When you sell a put option, your maximum loss is limited to the strike price minus the premium you collected.
Selling puts can be a great way to get extra yield on your cash while you wait to buy a stock at a certain strike price. Every month, I use options to generate extra income out of my available cash. When an option is assigned, I am happy to buy the stock at my preferred price and to start collecting dividends. (And I can get extra money from covered calls).