Options are not only a way of speculating and hedging but can be also used in a strategy to earn a stream of passive income.
There is not a great selection of brokerages in Europe that facilitate options trading and specifically trading US options. One of the best brokerages in terms of functionality and cost available to European retail investors is Interactive Brokers. We will be using Interactive Brokers to show you a real-life example of selling put options in practice.
Why would an investor want to sell put options?
The strategy we will be talking about in today’s blog post suits individuals who are interested in buying a stock and have completed an in-depth analysis of a company and believe it to be overvalued.
Rather than just holding some cash aside and waiting for the price of a stock to drop a fair value the investor is willing to pay. The investor can earn passive income while they wait for the price to drop down to the price that they wish to invest.
There are two sides to every options contract a long and a short position.
When a person goes long/buys a put option they are giving themselves the right but not the obligation to be able to sell their stock at a predetermined price (strike price) at any time before the expiration date of the contract.
They will only exercise this option if the contract is in the money, this would require the market price of the stock to drop below the strike price of the option.
In order to have this option the person buying the contract must pay a premium to the person willing to take on the other side of the contract (the person who is selling the put option).
This is where you come in.
Let’s say you think that the price of the stock you are interested in could drop to the level you want in the next 90 days (or any time frame for that matter).
You could sell a put option (setting a strike price close to the price you want to invest in the company) and get paid a premium while you wait for the price drop to play out.
This option would be currently out of the money as the market price is above the strike price.
For this example we analysed EBAY which is currently priced at $52 and believed the fair value price was really $45. We would be happy to invest in EBAY but only if the price was to drop to $52.
We have enough cash set aside to buy 100 shares of EBAY @$45 – $4,500.
We think there is a good chance it will drop to this level by September so choose to sell a put option with a strike price of $45 that expires on September 16th 2022. Approximately 150 days from now.
Selling this put option will earn us $245, which is the Ask price in the screenshot above $2.45 multiplied by 100. Remember that every options contract is the right to buy/sell 100 of the underlying stock.
$245/$4,500 works out to a return of 5.4% over the 150 day period. Not too bad right? This is not even the annualised rate which works out to 13%.
Generally the more volatility there is in the market at the time the higher the premium you can get for selling put options. Volatility is good when it comes to options.
Next up we will go through all of the potential outcomes of this strategy.
What are the potential outcomes of selling put options?
The above is a pay off diagram with the share price on the x-axis and the profit/loss on the y-axis.
Scenario 1 – EBAY PRICE REMAINS $52
In this scenario, the option remains out of the money for the duration of the contract therefore the investor who bought the option will not exercise it.
You earn your premium of $245, but the price hasn’t dropped to the level you want to actually invest in the underlying stock.
At this point, if you still believe the stock price will you could sell another put option and earn more passive income while you again wait for the price to decrease.
Scenario 2 – EBAY PRICE INCREASES TO $56
Similar to scenario 1, the investor who bought the put option will not exercise the contract as it remains out of the money.
You earn your premium of $245 but have possibly missed out on buying the stock at its bottom. Maybe your analysis was incorrect to think that the stock price would decrease.
But if you still believe the stock is overvalued you can sell another put option and wait longer for the price materialise.
Scenario 3 – EBAY PRICE DROPS to $43
In this scenario your prediction came true.
As the option is now in the money the person who bought the put option will now exercise their right to sell their shares to you at the strike price of $45.
You still earned your premium of $245, but now must purchase the 100 EBAY shares costing you $4,500 in total.
If you never sold the put option in the first place you would have been able to buy the 100 stocks for $4,300 instead of the $4,500 you are paying now. But you are actually better off by $45 when you add the premium of $245 into the equation.
The risk you run is that the price actually falls much lower than $43 in that case you would have lost out. But if we go back to the mindset you had when you took out the option. $45 was a fair price you wanted to get in at so you are happy that you got in at the right price for you.
What are the pitfalls of selling put options?
Price of Stock is Important
As options in lots of 100 so if you were to try and use this strategy for Tesla which is currently priced at $900 you would need to have cash set aside of $90,000 to cover the position which the majority of people will not have. Therefore if you are trying out this strategy you will be sticking to stocks with lower prices.
You need to hold a large amount of cash on the side to cover the margin requirements if the option was to very be exercised.
You Won’t Earn Dividends Etc
The cash that is sitting their to the side can be losing value due to inflation and also as it is not invested you wont earning interest or dividend income apart from the options premium you are due.
Options trading isn’t for everyone and it has far more complexities than regular stock trading. You need to be aware of additional variables such as implied volatility and the Greeks (Delta, Gamma, Vega and Theta).
But if you identify an overvalued stock that you are determined to buy when it reaches your target price then you can at least get paid for waiting for that to happen by selling put options.
Of course, you could also try and profit from the price decrease also by shorting the stock.
Disclaimer: This blog post is for informational and educational purposes only and should not be construed as financial advice. Options are complex instruments and come with a high risk of losing money rapidly due to leverage.