One of our favorite strategies is naked put selling. We only do this with securities we would be willing to own. When we can’t find anything to buy at prices we like (for example the market has risen to new heights), we may sell puts on stocks we would be willing to buy if they fell back to a level we were comfortable with. If we get put the stock, we are no worse off than had we bought it at that price. If we don’t get put the stock, we captured a nice premium and go our merry way. Never do this strategy as a way to solely create income. You will inevitably get put a stock you don’t want to own and the money you made on the option sold can be dwarfed by the amount you lost getting out of the position.
We are going to illustrate this strategy using Procter & Gamble, a blue-chip stock. Let’s say that P&G has been trading in a fairly defined range between 60 and 65. The company also pays a healthy dividend of about 3.3% per annum. Now 3% isn’t bad considering you get next to nothing at the bank, but the strategy we are going to demonstrate will earn you closer to 15 to 20% per year.
For our purposes, we’ll say that we see the stock has been trading in a range between $60 and $65 for the most part. Let’s say that you’ve done your fundamental research on Procter & Gamble and you decide that this is the kind of company you would be willing to invest in. However, you’d rather not buy P&G at the upper end of its price range ($65). Instead you would prefer to buy it at $60 or below.
In order to create a position in Procter & Gamble below $60 you would sell the April 60 puts. If the April 60 put is trading at $1.45 then you would collect the $1.45 premium for each hundred shares you sold, or $1450 for 1000 shares of Proctor and Gamble. That’s it. You don’t have to own P&G to sell someone the right to put you the stock at $60 sometime before the 3rd Friday of April. The brokerage firm that is handling the transaction will put $1450 into your account less commissions.
Now why would someone would pay you $1450 for the right to sell you Proctor & Gamble stock at $60 when its trading at $63? For starters, they may fear it could go lower than $60 in a weak market. Or this person may simply be a speculator who thinks they know something about the stock that you don’t. In either case, you’ll never know the reasons why, just take the money and run.
So if this is so brilliant, why isn’t everyone doing it? First of all, a lot of market pros are doing precisely this. It also takes a lot of money in your account execute this strategy. Although selling puts on P&G puts $1450 into your account, your brokerage firm is going to want to see that you have sufficient funds in you account to pay for this transaction if you get put the stock. One thousand shares of P&G at $60 is $60,000. A far cry from the $1450 put into your account. It takes money to make money. Take some consolation though, most brokerage firms will allow you to do this on margin and have just 25% of the underlying option contract value less the premiums received. (This number varies from firm to firm).
Now let’s say the 3rd Friday comes along and P&G has done what its done for several months: nothing. You keep the premium and do this again for the next option cycle. All standardized equity options use American-style exercise. So it’s entirely possible that if P&G is trading below $60 you may get exercised before the last Friday of the month. You have to have the capital at hand in the brokerage house the entire time this option strategy is in place.
Realistically though, is someone going to put me P&G stock before expiration? Nine out ten times the answer is no, even if P&G is trading below $60. But one out of ten it is going to happen and it’s not worth trying to figure out why. The important thing is to remember that it will happen sometime. If P&G is $60 or higher on this expiration Friday, there is no chance you will be put the stock. So what does that mean? That means you have collected $1450 for doing absolutely nothing but being willing to buy P&G for $60 and waiting for the 3rd Friday of each month to make this decision. This strategy is called writing puts, selling puts, or selling puts naked. They’re all the same. And contrary to what some advisors may say, this is one of the most conservative, safest equity strategies. THIS IS ONLY IF YOU ARE TRULY WILLING TO BUY THE STOCK. After all, if you get put the stock, it also was trading in a range you thought was a fair value, so you’re no worse off had you purchased it outright.
Okay, sounds good. What about buying P&G at $60 at your option price when the stock is now trading for $45? What? How could that happen? Easily. Say the market crashes the week your options expire, or P&G has a product recall that killed hundreds of people, or maybe a European bond auction fails. The point is you can’t predict these events anyway, so at least you bought at a price that was at a discount at the time you sold the put.
The prior example is a great way to create a synthetic long position. Now look at what happens when you buy the stock at the bottom of the range and sell a call toward the top of that range. When you sell the call, you give someone the right to buy P&G from you instead of selling it to you. It’s called a covered call. You believe, based on the past six months price behavior, that Procter & Gamble stalls out around $65. This stock appears to be going nowhere at this point, but the company continues to pay a nice dividend. This is a good time to sell a covered call.
Now in this case I’m able to get $2.20 per call for one April 65 option. Just like a put options we sold in the previous example, each call option represents 100 shares of a stock. So if I sold 10 calls that would put $2200, less commissions, into my brokerage account. Now I’ve given that the buyer of that call the right to buy my Procter & Gamble, so I better have Procter & Gamble in my account to cover my obligation. What’s the worst case that could happen to me here? I sold P&G at $65 at the top of the trading range. I also collected $2200 in option premium. Or I lost a runaway stock that will go much higher. Or I capped my gains at $67.20 ($65+$2.20). Or P&G did not reach $65 and is in fact lower and I now have the stock I owned plus the $2200 premium.
An excerpt of “The Investment Survival Guide”