The insurance business is a very profitable one. Insurance companies insure you against sickness, car accidents or death among so many other things. They bet that they collect enough premiums from you to cover their cost and make substantial profits. It is a number game. The more people they insure the higher the probability they win their bets. They hardly do wrong.
And as an investor, you can act in a similar way. You have the opportunity to “write insurance” for speculators or other investors and collect the premium just like an insurance company does. It’s a conservative strategy that can generate a lot of income.
This is a way to do it: You identify when a stock is an attractive buy, most likely below the current market price. To enter the market, you use options. But you do not buy an option, you sell it. You are just taking the other side than usual. In fact, you are selling put options at the strike price where you identified the stock to be a steal and you want to own the stock any.
A put is a bet that the stock will go down. If it does, the value of the put increases, offsetting some or most of the drop in stock price. It works like an insurance. If the stock goes up, the put expires worthless.
An individual investor can sell the put to the other party. Just like an insurance company is obligated to pay a claim after an accident, the put seller is obligated to buy the stock from the investor at the strike price, usually a heavy discounted price of the current market price.
The premium paid by the buyer of the put is placed in the put seller’s account and can be used immediately. May be, for another lucrative investment or for a rainy day. The seller now waits for the put option to expire on expiration date.
If the stock or index closes above the strike price, the put expires worthless. It’s the same as a life insurance premium: if the person is still living, the insurance company keeps the premium. And so does the put seller, he keeps his premium paid to him. In this case, you got paid for waiting but not being able to buy the stock at a discounted price.
Now, if the stock drops below the strike price, the owner of the put has the right to sell their stock to the put seller at the strike price.
Let’s assume the stock is trading at expiration at $49.00, the put seller sold at a strike price of $50.00 and received a $0.50 premium. The investor exercises the option because the put seller has to buy the stock at $50, even the stock is currently trading at $49.00 below the strike price. But the put seller can still keep the $0.50 per share premium. So his real cost to buy the stock is $49.50 per share.
Because of the risk of being forced to buy the stock, a put seller should sell puts only on stocks that they are happy to own at this discounted price. In our example, if the put seller is glad to buy the stock at $50.00, they would sell the put at a 50 strike price and additionally pocket the premium. And if the stock goes down and they have to buy it at $50.00, well, that’s just fine because the investor wanted to buy the stock at $50.00 anyway, when the market was much higher. In fact, deducting the premium, he only pays $49.50.
The risk is that if a stock falls sharply below the strike price (e.g. $46.00), the investor sits on a sizable unrealized loss but at a convenient level for him. Again, you’re fine with owning at a lower price. You would have bought at $50.00 anyway and you are slightly better off at $49.50.
If a put seller could make a similar trade every month, you can generate a substantial income.
You can also generate more income by selling more expensive puts but be aware that the more expensive the put, the greater the chance you’ll have to buy the stock. So, only choose a strike price at which you really want to own the stock anyway.
Option trading is considered very speculative. But in my opinion, selling puts isn’t for speculators but for conservative investors who want to generate extra income from their portfolios.
Sven Franssen