By Investment U on July 16, 2009
The “buy-and-holders” just got killed again…With the market’s plunge last week, many regular shareholders have seen their portfolios awash with more red numbers.
Tough break for them. But savvy investors know that this offers a great chance to value shop and buy back in. And one of the most effective and profitable investment strategies that you can use in a market like this is one that generates income… no matter what happens.
This can be done by selling put options.
So let me show you a little more about this options trading strategy - how it’s done and how easy it can be for the average investor.
Busting The Myths of Selling Put Options
If you’ve gotten this far, you’re on the right track. Many investors hear the words “put options” and “selling” in the same sentence and head for the exit. Too complex. Too confusing. And downright scary. Or so the myth goes.
Let’s bust that myth right away: Selling put options isn’t difficult to execute. In fact, it’s actually easier than most investment methods.
When you place a put-sell trade:
* You don’t have to buy a stock.
* You don’t have to sell a stock.
* It’s got nothing to do with bonds or currencies.
* And there are no complex parameters to the trade.
Here’s the deal: You’re either going to make money, or you’ll end up investing in a company at a ridiculously low, discounted price.What you try to do is buy stocks for the price you want. And just for trying, you get paid. Think of it like Priceline.com - where customers name the price they want to pay for airfare and hotel rooms - except with stocks. The biggest difference is that you’re getting paid for your time.It works in rising markets… falling markets… flat markets… any market. It’s a regular stock-buying strategy with a profitable twist upfront. Here’s how you can use it…
Selling Put Options In Four Easy Steps
Have you ever wanted to buy a stock but passed because the price is too high for your liking? Most ordinary investors would simply sit on the sidelines and wait for the price to fall to a better level. But smart investors know they can still get in the game by selling a put option on it instead.
Here are the four steps you need to take when selling put options:
* Pick your chosen stock.
* Decide on a lower price, where you’d feel comfortable buying the shares.
* Check the put option prices for that level. For example, if the stock is trading at $20 and you want to buy it for $15, you’d select the $15 strike price and an expiration month.
* You then sell those put options. Since each stock option contract is equivalent to 100 shares, you’d sell five put option contracts if you want to buy 500 shares.
When you enter a trade like this, you’re obligated to buy those shares at your stated strike price by expiration. Keep that in mind when selling the contracts, so you don’t overextend yourself. For example, if you sell one $15 put option contract, you’ll need to have $1,500 on hand by expiration day to cover the cost of the shares ($15 x 100 = $1,500).
Note: You don’t need to have all that money on hand while the trade is open. Your broker will only ask you to keep a fraction of that amount available - known as a “margin requirement.” Consider the trade as a “buy now, pay later” type of deal. You’re putting off paying for the stock until a certain scenario occurs (see below).
In exchange, the option buyer will pay you for each contract you sell while you wait. This is known as a “premium” and is deposited into your trading account. (The farther out the expiration date, the more money you’ll receive when selling the option.) Meanwhile, ordinary investors are waiting for the price to drop without collecting any money.
Okay, then what happens?
On options expiration day, you’ll have two scenarios when selling put options:
* If Your Stock Trades Below $15: For every put option contract you sold, you’ll be obligated to buy 100 shares at $15 each. This is what you wanted - a 25% discount from its $20 price when you executed the trade. Plus, you get to keep the money that the option buyer paid you. The shares will appear in your account on the Monday after option expiration. It will now be a regular long position and you must manage it as you would any other stock. That’s why it’s important you pick a price at which you’re comfortable holding the shares.
* If Your Stock Trades Above $15: The put options will expire worthless. You won’t get to buy the shares at your chosen price, but you will get to keep the money for selling the contracts, just for trying.
So regardless of what happens, you keep the money from selling the put options upfront. Now let’s bust another myth…
But Isn’t Selling Put Options Riskier Than Buying Shares?
Selling put options is no riskier than buying shares outright.
* When you buy shares, the risk is that you lose your entire investment.
* When you sell a put option, you’re obligating yourself to buy shares, too… but at a much lower level than the current share price.
* And if you do end up buying the shares, your risk will be the same as a regular shareholder.
The difference is that nobody pays you cash to buy stocks outright - but they do when you sell put options. Selling puts is just another way to invest in the options market.While some brokers see selling put options as riskier than stocks (and require that you keep more capital reserves on hand), your risk only kicks in if you’re obligated to buy the shares. And even then, you’d simply be long on the stock, with the same risks as with any stock holding.Perhaps the biggest obstacle for most investors is that you need to be “approved” to sell puts. This means that you must apply through your brokerage. It’s a simple process , similar to filling out forms when you opened the account.
An Important Note on Selling Put Options
Many folks don’t know about option trading strategies like put-selling, and Investment U will be working hard to bring you more like this in the coming weeks and months. But we wanted to give you an example of what’s working in the market right now.It’s certainly not as risky or complicated as some people would have you believe.And for those of you who know Lee Lowell, you’ll know he’s not a gambler. In fact, he’s one of the most conservative, risk-averse investors I know.
That said, selling puts isn’t necessarily for everyone. You’ll need to check with your broker to make sure you’re approved to trade options - and specifically, selling put options.
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