It’s April 2019, and we’ve just seen one of the best starts to a new year ever. The bull market off the 2018 lows was a primed for the long position but also ideal for selling puts. Using options to take advantage of the upside can be done in multiple ways. Selling puts on the move higher was a low-risk passive income strategy that could have been used by long portfolio holders or speculators alike.
Having rallied roughly 25% on the S&P 500 index, buying and holding equities on the rally or even the index were a strong play. If you had no intention of owning the stock, there are other trading strategies. That is selling puts! Selling puts is an options strategy that will be discussed further on in this article and is still a viable option as we near all-time highs.
There are risks to the passive income strategy of selling puts. When a trader sells options, they receive a flat credit into their account if the price moves away from the strike. In the case of selling puts, you would want price to move higher to secure the credit received. The credit is equal to the premium of the option. That means assuming you should sell Apple May 10th puts at a strike of 200. The bid/ask of the puts is $3.45/$3.55 respectively. When selling put you collect the bid premium of $3.45 or $345 per contract. Assuming price remains above the strike into the expiry of the option, only then will you collect the max premium.
There is a risk to selling puts, naked has the potential for a large drawn down. Unlike buying options, the risk is limited to the premium paid for the options contract, selling an options contract holds infinite risk, theoretically. Well as much as the stock is worth. As the price of the underlying can only drop to $0, which is the max risk of the position. Take a look at the profit loss diagram below that outlines the profit and loss position potential of the short put. To sum it up, the short put position has a limited max profit equal to the premium received for the position. Which will happen at expiry when the position expires worthless only if the underlying’s price remains above the strike. While the max loss is equal to the underlying current price. With near infinite max loss, there is however a way to cap the risk of selling puts. We will discuss this further in the following sections. One can use the short put strategy for trading short term or mixed with their long term portfolio.
Selling Puts-Trading Strategy
The trading strategy for selling puts is simple. In short, one can sell puts with weekly expiry as long as the underlying moves higher. This ensures the trader collects the premium of the short put on a weekly basis. This is a passive income strategy, however, it is important that the upside trend continues. As the bull rally in US equities has been ever-present throughout 2019, selling puts as markets continued to move higher was a perfect passive strategy.
Keep in mind there are other criteria to this trading strategy to consider, it’s not as easy as picking a stock of choice and selling puts on that underlying asset. Stocks are fundamentally driven by news and can swing sporadically, not the best for a passive, ladder put selling strategy. That is why at TRADEPRO we like to sell puts on indices and index-based ETF’s. Such as the SPY which we will be using as an example today.
But what about the infinite risk that we were going to diversify? We can’t just be selling naked puts, what happens if the index drops? Wipes out the premium received and then some. One alternative is to have a stop loss, should price move below a certain threshold. Or, turn the put strategy into a spread!
Credit spreads combine selling puts and buying a put to limit the potential loss to the difference of the spread. If you want more information check out the following blog on credit spreads, click here! The premise of the credit spread is to cap the risk and collect the premium of the put selling. When you enter into a bull put credit spread you collect the premium of the short put minus the premium you’ve paid for the long put at a lower strike price. For a credit-intensive strategy, check out this Iron Condor article, click here.
Otherwise, consider the following example. We’ve outlined three credit spreads on Apple as the upside prevailed. Each could be a week-long spread in which you collect premium from the move higher on the put premium. A great passive income strategy when the bull market is in full force.
Another example of the Apple credit spread in selling puts for income can be seen in the following Interactive Broker’s screenshot. We’ve outlined what a weekly credit spread on Apple would look like. The risk is capped but so is the profit, thanks to the spread.
Selling Puts-Investing Strategy
Selling puts is not limited to trading options purely speculatively for gain. An investor can take advantage of selling puts in their portfolios as well. This strategy involves creating passing income from the long positions already in your portfolio. So it does require the investor to hold the security in which they plan on selling puts. For example, if the investor has a large position in Apple. They can sell up to the position’s size in puts. Assuming the portfolio holds 500 shares of Apple. The investor has the opportunity to sell up to 5 contracts of Apple puts but keep in mind this opens the floor to unlimited risk. This strategy is called the synthetic short put. Remember with a short put position you would have to buy the stock from the long put side should it be exercised.
The idea behind selling puts in a portfolio is to generate passive income, should the stock not pay frequent dividends or should the investor want to generate some passive income in a bull market. Especially if the portfolio is largely in higher beta stocks on the bull run, selling puts becomes less risky as the underlying stock would move higher, faster.
Selling 5 contracts of Apple in the portfolio will generate approximately $500 of income weekly as per the spread above. There are however multiple conditions to this. First, the contract has to expire worthlessly, or above the short put strike, this ensures that you collect the maximum premium. Second, investors have to be cognizant of the potential downside, there is a possibility of having to buy the stock should you let the stock expire below the strike.
However, that can be limited by again implementing the credit spread into this portfolio strategy, this does decrease the max premium that you may collect from the position but it eliminates the risk of having to buy more stock to cover the position.
Selling puts is a great income generator however it does come at a cost if the risk is not managed. Be cognizant of the downside potential in this strategy. You may end up being obligated to buy the stock should the price of the underlying drop below the strike of the option. The possibility of using short puts or a combination of a credit spread is a great passive income strategy in bull markets. The bull market has been going for a decade now and if this strategy has been implemented, a lot of passive income could have been generated.
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable to your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.