Disclaimer: We here at skillbuilderdad.com are neither financial advisors nor professionals. This article expresses the opinions from the personnel at skillbuilderdad.com, and is for inspirational and educational purposes only. The investment decisions you choose to make are 100% YOUR responsibility. Investing of any kind involves risk, and options trading can involve BIG risk with BIG losses. It is recommend that you consult a financial advisor before making any trades.
When buying stocks, have you ever set a “limit buy” order? For example: let’s say Bank of America (BAC) is trading around $23/share, and you are willing to pay $22/share for the stock. You then set a Good-til-Cancel “limit buy” order, and when BAC drops to $22/share, your order executes. The order could execute the same day, or it might take weeks. Either way, you were able to purchase the stock for a discount of $1/share, which would be equal to $100 in your pocket if you purchased 100 shares. For those times when a “limit buy” order makes sense, selling a “put” option makes even more sense. What if I told you there was a way to still receive your $100 discount and as an added bonus, get paid to set your “limit buy” order?
Don’t believe me?
Well you can do it with a very simple options strategy, called “selling puts.” Taking the scenario explained above, let’s try doing the same thing but instead of setting a “limit buy” order, we will sell a “put” option. Below is a screenshot of an option chain from Interactive Brokers:
Credit: Interactive Brokers
Don’t be intimidated by the reverse background. The boxes/arrows were added to point out the main things you need to look for. The top-left boxes tell us that BAC is trading at $23.30 per share. The next few boxes tell us about the option chain: it expires in 29 days, and a 22-strike “put” option sells for $61 (remember, we must multiply 0.61 x 100 = $61, because each contract is for 100 shares).
This is where you get paid to buy a stock
If you were to sell the put option at a 22-strike, then you will have collected $61. You have 29 days for BAC to dip below $22/share. At the end of 29 days, if BAC is below $22/share, then your option will be exercised, and you will own 100 shares of BAC at $22/share, with an additional $61 in your pocket! You just got paid to buy 100 shares of BAC.
This might not sound like much, so let’s look at it in terms of percentages: return on risked investment is 2.8% ($61 / $2,200) in one month. Annualized gain is over 33% (2.8% x 12 months).
Scaling up, if you sold ten contracts (10 x 100 = 1000 shares) then you would have made $610 in one month. Return percentage of course remains at 2.8% ($610 / $22,000) for one month.
Wow, that’s cool. But what if BAC stays above $22/share at the end of 29 days?
Similar to a “limit buy” order, your order will not execute, and you will not own any shares of BAC. The bonus is that you get to keep your $61 per contract. In this case, instead of getting paid to buy stocks, you are just getting paid which is a better alternative in my opinion. In fact, this can be an entirely alternate strategy, where you collect money every time you sell a put option, hoping the stock never dips below your strike price. I will outline this “alternate strategy” at the end of this article.
What if BAC goes WAY below $22/share at the end of 29 days?
Similar to a “limit buy” order, your order will execute and you will own 100 shares of BAC at $22/share. You also get to keep your $61. This is why you should only sell put options on a stock you are willing to own for a long period of time.
What if BAC dips below $22/share within the 29-day time frame, but then goes back up before the contract expires?
Contrary to a “limit buy” order, if BAC dips below $22/share any time within the 29-day time frame, your option may or may not be exercised, as the exercise decision is left with the person (or algorithm) who purchased the option contract from you. Fun fact: American options can be exercised by the buyer at anytime, whereas European options can only be exercised at expiration.
Concluding advice:
- You have the choice to buy back the option contract at anytime during the 29-day time frame. Remember, when the stock price goes up, the put option value decreases. When the stock price goes down, the put option value increases.
- As part of the alternate strategy outlined in the last portion of this article, if you do not care to buy the stock but would rather collect a portion of the $61, you can buy back the option at a lower price, closer to expiration (assuming the value of the option decreases).
- ALWAYS, ALWAYS, ALWAYS make sure you have the cash in your brokerage account to buy 100 shares of the stock for every option contract you are selling. This means that if you sell 1 option contract, be prepared to have 100 shares of the stock “PUT” to you (buying 100 shares) at the strike price you are selling. If you sell 10 option contracts, be prepared to have 10 X 100 = 1,000 shares “PUT” to you (buying 1000 shares) at the strike price you are selling. If you don’t have the cash to back it up, your broker will find other ways to get their money (cars, house, etc.).
Alternate Strategy: Get paid to buy stocks
The original strategy with a twist: sell a put below the stock price as expected, but instead, your strategy is that the stock never goes below your strike price. This can be thought of as a way to sell insurance to make a profit. If the insurance buyer does not use their policy (option not exercised), then the policy (contract) expires worthless, and the insurance seller (you) get keep the amount paid for the policy (contract).
You are now equipped to “Get paid to buy stocks” or simply “Get paid” by selling put options. Have fun, and remember to ALWAYS have enough cash in your brokerage account to buy the stock. An easy calculation: STRIKE PRICE x #CONTRACTS SOLD x 100 = CASH NEEDED IN $$$.