First, it’s essential to know what an option is. when done we could start investigating how Selling Options for Income.
Table of contents
- Put Option (explained)
- Selling Options (howto with example)
- Selling options – have three outcome
- Who would you rather be when selling options?
- Real-world example
- Selling Options on the SPY ETF
- Generate Income by selling covered call option
- Now with real numbers
- Selling options rule of thumb
- Apple example (howto)
- What not to do when selling options
- Conclusion
Put Option (explained)
A put option is a contract between a buyer and a seller that specifies four things:
- Rights and Obligations
- The underlying security or commodity
- The expiration date
- The strike price
And with a put option, the seller sells the option to a buyer. And the put buyer gets the right, but not the obligation, to sell equity or commodity to the option seller, within a specific time period, and a set price.
In other words, the put seller may be required to buy something, from the put buyer, should the buyer decide. And the put option specifies what that something is, the underlying security or commodity, along with a strike price, and expiration date.
So the buyer has the option to exercise his or her right at any point until the contract expires.
Selling Options (howto with example)
Let’s consider the following example, of Dan & Sally and coffee beans. Dan has a warehouse full of coffee beans. And Dan is worried the price of coffee could go down in price.
So, he wants to protect his stash of coffee. Sally isn’t so concerned. Sally buys coffee regularly and thinks the price of coffee is pretty stable, or might go up, but not too much over the next month.
Today, coffee beans cost $10 a pound (a.k.a the underlying stock). And Sally decides to sell an option contract to someone that goes like this. Sally sells a contract to Dan, the buyer, who will have the right, but NOT the obligation, to sell her some coffee beans, for $10 a pound, at any point until the contract expires, in one month.
And Sally offers this contract for $1.00 a pound, and the contract is for 100 pounds.
So $100 Confused? I was too when I started learning about selling put options.
Let’s go over it one more time. Sally sells the contract to Dan. So, Sally is the put seller, who might buy Dan’s beans if he decides it’s worth it. Now, you might be wondering,
WHY would someone want to buy such a contract? Well, Dan has a warehouse full of coffee beans, and he wants to protect his investment.
Selling options – have three outcome
So, if the price of beans goes down, Dan can sell them to Sally for a higher price. The price that’s specified in the contract! So, Dan agrees and he’s willing to sell Sally 100 pounds of his coffee beans for $10 a pound, at any point until the contract expires, next month – if HE wishes.
And he pays Sally $1 a pound for this option, or $100. This contract is called a put option. So Dan paid Sally $100 for this option. The $100 is called the option premium, or the income that Sally gets to keep, no matter what happens to the price of coffee beans.
Fast forward to next month, and now we have three possible scenarios.
Scenario 1
The price of beans goes down to $8 a pound. Uh oh! Well, Dan is happy, because now he’ll sell 100 pounds of his coffee beans (underlying stock) to Sally for the contracted price of $10 a pound because now they are worth $8.
Sally pays Dan $1000 for the beans, even though they are only worth $800. But, she did collect $100 from Dan earlier. So for Sally, it’s a bit of a loss, but it’s not the end of the world.
Scenario 2
At expiration, coffee Beans still cost $10 a pound. Bean prices were pretty stable, so the option expires worthless. Now, if Dan wants, he could sell Sally the coffee beans, but, there would be no reason to do so because the price is still $10. He could sell the coffee beans to anyone for the same price or just keep them. But Sally keeps her $100.
Scenario 3
The price of coffee beans goes up to $12 a pound, just as Sally predicted. Woah. Now what? Remember, the contract says, Dan can sell Sally 100 pounds of coffee beans at any point before the expiration date, for $10 a pound. Well, why would he do that now?
If Dan wanted to sell his coffee beans, he could sell them to someone else for $12. So, again, the option expires worthless, and that’s what every option seller wants. Either way, Dan loses his $100. But Sally is happy because regardless, she got to keep her $100. And Dan is happy because coffee costs $12 a pound.
Who would you rather be when selling options?
Who would you rather be? Dan, or Sally? So you see, people buy put options as a form of insurance against the price of the underlying equity or commodity going down. And the put seller assumes all the risk but gets to keep the income.
If you sell options on the underlying stock that you own in your stock portfolios, you are able to generate consistent income. by using the options trading strategy you are hoping to sell options for premium income, that eventually the option expires worthless.
I hope it wasn’t too confusing. If it was, take a moment, go ahead and read it again,
Now I’m going to talk about some real-world examples.
About how you can start making a weekly or monthly income by selling put options. First, remember, Options are just contracts that have rights and obligations.
Real-world example
For example, those who buy put options have the right to sell something specific to the option seller at any point before the option contract expires, at a specified price, the strike price. And In exchange, the put seller collects an option premium, the income, from the buyer.
And, this premium is guaranteed income that the put seller gets to keep, every time they sell options, regardless of whether they are weekly or monthly, or even yearly. Yes, you, the put seller, can repeat the trade, again and again, week after week, month after month, and keep the income, no matter what happens.
But, like any investment, you’ll need to know some basic things about selling weekly or monthly put options for income.
In particular, it’s important to understand the mechanics, the rights, the obligations, and the overall risk. Typically, retail investors like you and I, buy and sell put options on equities like an index ETF, not on commodities like coffee beans.
Though, I like the coffee example, because to me, I love coffee, so I can relate, at least a little. One of the things people often sell puts on is the SPY. The SPY is an ETF. It’s the most famous S&P 500 index ETF and it works like this.
Selling Options on the SPY ETF
1 put Option on the SPY allows the put buyer the option to sell the put seller 100 shares of the SPY ETF for a specific price, known as the strike price, before the expiration date. That’s all.
And the seller collects income, the option premium, for selling the put! So, what do you need to sell put options? Well, remember, when selling a put option, you’re giving the buyer a right, but not the obligation to sell you the underlying commodity or security.
In other words, you may need to be able to buy the underlying commodity, stock, or ETF. So, you’ll need enough collateral. Collateral will be in the form of cash or margin in your brokerage account. Remember, you, the put option seller agree to buy something specific, in the future, if the buyer requests it.
So, your brokerage account needs to have enough money, or collateral, for you to afford the purchase. For example, if you want to sell 1 put option on the SPY, you’ll need to be able to buy 100 shares of the SPY ETF in your brokerage account at the specified strike price.
Now with real numbers
If the strike price is $300, then you need to be able to afford to buy $30,000 worth of SPY! And, if you want to sell 5 put options and earn 5x the money, you’ll need to have enough cash or margin available to purchase 500 shares of the SPY in your brokerage account.
Also, options typically expire on the 3rd Friday of each month. However, many stocks and ETFs now offer a wider range of expiration dates. For example, the SPY has options that expire on Mondays, Wednesdays, and Fridays of each week!
In other words, you could start selling weekly put options and collect income as much as three times a week, every week! In general, you can earn anywhere between 1 and 5% or more a month selling weekly or monthly put options, it all depends on your trading strategy.
How much you earn depends on how volatile the stock market currently is, the strike price, and the expiration date. In other words, the more risk you are willing to take, the more income you can collect. Similarly, the more unstable the markets are, the greater the income.
Selling options rule of thumb
In order to generate income, I prefer selling put options slightly “Out of the Money,” with an expiration of 3-6 weeks out. An “Out of the money” put option means the strike price is lower than the underlying equity. Now, you might be wondering about the risks of selling put options.
First, you must remember that by selling weekly or monthly put options, you agree to buy the underlying equity should the put buyer wish, at any point, until expiration. The risk in selling puts is that you might end up being forced to buy something for much less than what it’s worth.
So, manage the risk, you need to be sure that whatever you are selling a put option on, that it’s a quality stock or ETF that you’d be happy to own, at the agreed strike price.
And, once you own it, you can do whatever you like.
Apple example (howto)
Let’s look at a real-world example. Let’s talk about Apple. Let’s say Apple is currently selling for $130 per share. And You think Apple is on its way up.
So, you decide you want to sell a put option with a strike price of $130, that expires next month, say July 17. Your brokerage tells you that investors are buying the option for $4. So, if you sell this put option, you’ll collect $4 of income, times the number of contracts you trade, times 100.
if you sell one contract, you’ll get $400 of income, or option premium, that you can keep no matter what happens. It’s guaranteed income.
Case no 1
Now, let’s fast forward to the expiration date. Let’s say Apple is now trading at $120.
In this case, you’ll be forced to buy 100 shares of Apple for $130 each, even though they are only worth $120. But, don’t forget, you’ve already collected $4 for the put option! You’ll only lose if you sell apple shares at a loss. But, let’s examine the 2, more exciting scenarios.
Case no 2
Let’s say that on expiration day, Apple didn’t move much, and it’s still selling for $130. Remember, you’ll be fully profitable as long as apple stays above the strike price, in this case, $130. Since $130 is the same as the strike price, it means nothing happens. The put option expires worthless, which is what you want! And of course, you get to keep your $400 income.
You can repeat the trade next week, next month, or next year. And finally, the same will happen if the shares go up in value, above the strike price. The option expires worthless, and you get to keep the $400 income no matter what.
Now, remember I mentioned I’d give you the 1 thing I think you should not do when selling put options?
Generate Income by selling covered call option
Covered Calls: How They Work and How to Use Them in Investing
A covered call is a two-part strategy in which shares are bought or owned and calls are sold on a share-for-share basis.
An example of a covered call is when an investor buys 100 shares and sells 1 call option at the same time.
Meaning, when an investor has owned 100 shares for some time and now decides to sell 1 call against those shares.
Regardless of whether the shares are bought before the calls are sold or bought at the same time, the resulting position is called a “covered call position”
Risks of a covered call
Risk of losing money when the stock price falls below the break-even point.
The break-even point is the purchase price of the stock minus the option premium received.
As with any strategy that involves stock ownership, there’s a significant risk.
Even though stock prices may only fall to zero, that’s still 100% of the amount invested, so it’s important that covered call investors are able to bear the stock market risk.
As long as the covered call option is open, the writer of the covered call option is obligated to sell the stock at the strike price. Although the premium offers some profit potential above the strike price, this profit potential is limited.
Therefore, the writer of a covered call option doesn’t fully participate in a rise of the share price above the strike price.
Are Covered Calls a Profitable Strategy?
Covered calls may or may not be profitable. The highest profit from a covered call is achieved when the stock price rises to the strike price of the sold call and no higher. The investor benefits from a slight increase in the stock and collects the full premium of the option if it expires worthless. Like any strategy, writing covered calls has advantages and disadvantages. When used with the right stock, covered calls can be a great way to lower your average cost or earn income.
What not to do when selling options
Selling put options is a guaranteed way to earn weekly or monthly income, and yes, it can be very profitable, month after month. The key is to remember to sell put options on only high-quality equities or ETFs that you would actually want to own, because you may be forced to buy them.
And You might be wondering if you can lose money selling put options. Well, you’ll never lose the income from selling put options. The income you receive from selling puts is guaranteed. However, if you’re forced to buy the underlying equity, AND you sell the equity at a loss, then yes, that might lose money.
And last, but certainly not least, I wanted to give you a plan B. Something else that you can do to reduce your potential risk, or make even more money selling put options. When you sell a put option, if the equity has gone up considerably, your option will likely be profitable.
You could always close out your trade by buying back the identical option, at a lower strike price.
Now, why would you want to do that? Well, you then could sell another option and repeat the process.
Conclusion
If this is your first time considering selling put options, I know you may be confused. I know I was. So if you’re still confused, go ahead and read this article a few more times. By the way, which tip did you like the most? And do you already sell options?
related articles – Selling put option for income and Is poor man’s covered call a good strategy?