WHY: To get paid while waiting for a lower share price that you’ve been wanting to buy at and you wouldn’t mind buying at a lower price. You’re expecting the stock price to move higher (eventually) or at best remain flat, but would like to collect some premium while you wait, you sell a PUT option contract. Think of this is a stock buying strategy — we call this Cash Secured Puts.
Selling (or as we like to call it ‘writing’) a PUT option contract allows you to get a lower entry price and generate some cash flow while waiting for the stock price to go lower. Normally, you would write the option lower than the current trading price.
This actually will allow you to kick start a brand new portfolio, because instead of buying at higher prices immediately, you can write PUT option contracts, wait for the price to fall and if exercised — you’ll have a lower entry price. Some also use this strategy, to average down their price for a particular stock in their portfolio.
For example, you have shares at $50 and expect it to go to $60 BUT you think it ‘could’ move down in the near future, you can sell (write) a PUT option contract for a strike price of $45. One of three scenarios could pan out…
If the price remains above $45 on the expiry date, you get to keep the $2 premium (as the option seller/writer) and you can start the process of selling (writing) another option again — i.e. rinse and repeat.
If the price drops below $45 to $44 on the expiry date, you get to keep the $2 premium (as the option seller) but the option can be exercised by the option holder who bought it (remember, you sold a put option contract to someone, anyways the broker would do this work of assigning it for you) and you would have (been obligated) to buy it at $45 — $2 (because you collected the premium) or $43 per share.
If the price drops way below $45, to say $20 (because the CEO is being held on fraud charges or some creative accounting scam), your entry price would be $43 per share, but you’d still be down. The good news is that your loss would be less than if you had simply bought the stock outright at $45. (The bad news is that if the stock doesn’t recover, you could end up holding it for a very long time!) Anyways overall, options are good way for limiting your losses, and improving your returns.
Catch 22: Well, similar to covered calls — you must be prepared (i.e. ready and happy) — to buy shares if it falls to the strike price. What’s more in order to sell puts, you must have a margin account. You don’t necessarily need to use the margin facility, you just need to keep more cash in the account. The more money you want to make, the larger cash balance you should keep aside or risk having a ‘margin call’ made by your broker.
In any case, you’ll require a trading account that has been margin-approved and has all option facilities activated by your broker. Sign up for the bonuses - and how you can get approved by your broker to operate an online options trading account.