If you want to create cash-flow by selling puts you should go through the following process:
You know exactly at what price the underlying investment is trading. Now, you can guess, where it will or won’t go in the future. But what I do know for a fact is that there are 3 chances of winning using the put selling strategy and only 1 chance of winning if I’m making a one-way bet.
When selling puts, you have to be aware that you have the obligation to buy the underlying during the set time until expiration of the option, if the stock drops below the strike price. Here is a an example of what to do.
We assume stock ABC is trading at $35. Now you have a few choices:
1. You could buy the shares outright or the call options at $45 and hope both go higher.
2. You could buy a put option and hope it goes lower.
3. You could sell a put option and win if it goes higher, lower or stays where it is, as long as it doesn’t go much lower than the strike price.
So by selling a put, you have 3 possibilities to make a profit. If you identify a very attractive stock you can even use the strategy at an entry with a discount. In our example: If you sell a put of stock ABC with a strike of $30 you will receive a premium to do so. Now, either the stock goes up, then as a result you can keep the premium. If the stock goes nowhere, you can also keep the premium paid to you because the option expires worthless. Does the stock drop just above $30 you are still good and can keep the premium because still at this price the option expires worthless. If the stock drops below $30 by expiration date, you have to buy the stock at $30 but you still keep the premium and this reduces your entry price further (strike price minus premium).
In the worst case scenario, you own stock ABC that you believed was attractive at $35 with a huge discount of at least 20% or more. In all other scenarios, you are paid for waiting to be able to buy an attractive stock at even a better price.
But pay attention to the following important rule: The stock has to fall strongly in order for you to lose. So, it is very important that you only use this strategy with an underlying that you want to own in your investment portfolio. When you sell puts, you want the value to move lower because you want to take on this in your opinion low risk, high probability of profits trade.
Sven Franssen