How is it done? Well there are a couple of different methods, this is one. We will go over the other at a later date.
Let's start with a company (AAPL) (this is not a recommendation - just used for demonstration)
At the end of today these are AAPL's numbers, Last Price is $383. This is a bit overpriced for my liking but if Apple were to come down to 370 I would pick up a 100 shares in a heartbeat. Maybe I see 370 as a fair valuation of the company or at that price it will be pulling back to a strong support level.
So now that I have the price I want it at I could sit on my hands and wait for it to drop or I could sell puts to make some money while I wait.
Here is our option chain for October:
(calls on the left - puts on the right)
For our purpose we will only look at the right side. When you short puts to pick up the stock you look for the stock to drop in price under the strike and you will be assigned (given) the shares. So as you can see there just so happens to be a 370 strike which is the price I want Apple for. The last price traded on the 370 puts was 12.15.
If we sell 1 contract (100 shares) we collect (12.15 x 100) $1215 while we wait for Apple to drop.
Sounds simple, right? Well it is, but we are not done yet. We still need to discuss how far out we sell our premium, what happens when we get assigned, what happens if we don't get assigned, and what the pitfalls of this strategy are.
How far out do we sell premium?
To answer this question we have to level the playing field. Obviously an option expiring in a couple of weeks can't compete on premium to an option expiring 6 months from now. First we need to find out the annual return of our premium.
The formula we will use is:
(( 1 + (Premium) / (Cost of Shares) / (Days to Hold)) ^ 365) - 1
looks like a complicated formula but it is really simple
so for our example:
(( 1 + (1215 / 37000) / 44) ^ 365 ) - 1=
(( 1 + .032837838 / 44 ) ^ 365 ) -1 =
(( 1 + .000746314 ) ^ 365 ) - 1 =
(( 1.007463145 ) ^ 365 ) -1 =
1.312985029 - 1 =
31.30% annualized return
Yes that is right. You have the option of sitting and waiting for the stock to come down to 370 before you buy it, or you can sell puts to collect a 31.30% return while you wait. Use this method of figuring out the annualized return for different expiration months so you can find out which month is offering a better return. Keep in mind that you don't want to get crazy with the holding period. You will have to keep this cash sitting aside just in case your option gets assigned. Typically 1 - 3 month holding periods work the best, but try a couple out to find out for sure.
If selling puts becomes a normal habit of yours, go ahead and make an excel spreadsheet to make these calculations quick and efficient. Let me know if you require help creating a spreadsheet.
What happens if we get assigned?
Getting assigned is having the stock fall below your strike and forcing you to buy the shares. This is the scenario you should be counting on if you are selling cash-secured puts. If at expiration Apple is .01cents below 370 you will be assigned the shares, and have to pay out $37,000. However, since you sold puts your average price is not 370 for the shares but is actually 370 - 12.15 = 357.85. Now that you have the stock you can start thinking about selling calls to generate extra cash. We will describe this strategy at a later date also.
What happens if we don't get assigned?
If we don't get assigned then the puts will expire worthless and we keep the premium. This has its advantageous because we still make the $1215 premium, which is a 3.28% return, and we will not have to pay another commission to close out the position.
What are the pitfalls of this strategy?
Every strategy has its pitfalls and this one is no different. Let's say you sell the puts but the stock does not come down and begins to move higher. At this point you would not be able to take advantage of this run up since you only have puts and not the stock. What you can do in this situation is buy back the puts for a cheaper price, thus making a profit, and then sell more puts at a higher strike. Another scenario is if the stock falls below your strike and keeps falling. This will assign you shares at your price, in our example 370 with a breakeven of 357.85. If the stock falls below that point you will have a loss. One way to think about this scenario is that you were planning on buying Apple at 370 anyways, at least this way you have lowered your breakeven.
Hope this method helps you use options to your advantage and generate extra income when investing in stocks.