We discussed on Monday the value of covered calls on long-term positions when the S&P 500 presses to overbought territory on the Relative Strength Index (RSI) and the Money Flow Index (MFI).
Today, I want to discuss another lower-risk, conservative strategy for long-term investors. Remember, we talked about “writing” or “selling” calls on the existing positions on Monday.
But there’s another way to sell. And this one is much different.
I’m talking about selling put options to generate income or to pick a lower price at which you’d be comfortable buying the stock. Today, I’ll offer you a step-by-step primer on how to get started by selling put options.
Understanding the Trade
Most first-time traders buy put options because they bet a stock will go lower.
But the reality is that institutions and expert traders BUY puts to hedge their existing long positions in times of uncertainty. If you’re new to puts, let’s do a quick recap.
A put option is a contract that gives the buyer (or holder) the right, but not the obligation, to sell an underlying asset like stocks or commodities at a predetermined price on or before the contract expires. In the world of equities, one put is a contract that covers 100 shares of stock (just like a call option).
As the put seller, you give the put buyer the right to sell their shares to you. But, the stock must fall under that strike price before expiration. Otherwise, it expires worthless, and you keep the money as the seller. The money collected for selling the put is known as the option premium.
If the stock does fall under the strike price – and the buyer exercises the option – you are obligated to purchase the stock at that set price. Let’s look at an example of this trade.
A Trading Example
Let’s stick with that example since we used Ford Motor Co. (NYSE: F) this week.
Ford shares traded for $10.63 per share Wednesday. Now, you might think Ford is expensive at this level, or maybe you’d be happy buying it cheaper. You hope the price will stabilize or increase over the next three months.
Looking out to Ford’s options chain, the February 16, 2024, $10 put sells for $0.40. Say you decide to sell two of these contracts.
This means you’d be willing to buy 200 shares of Ford stock at $10 on expiration.
And, since you have two contracts, you’d multiply 100 shares by $0.40. You’d receive $40 per contract, or $80 total.
Now, it’s worth noting that you must put up a margin with your brokerage so there is money in case you are assigned the stock. Since you’re willing to buy 100 shares at $10, that would be $1,000 initially. But you will take the $40 premium, meaning only $960 remains in the margin requirement.
Based on this sale, you’d generate 4.1% over 79 days, a pretty good return.
What Happens Next?
There are three scenarios of what may happen based on the current state of the markets.
- No. 1 — Profit: The stock price remains above the strike price, and you keep the premium as your profit. Let’s say that the stock rises to $11.00 in the next few weeks. That would drive down the cost of the option you sold, giving you a gain on paper. So long as the contract expires with the stock above that strike price, you’ll pocket the entire premium.
- No. 2 — White Knuckle Neutral: In this case, the stock price remains around the strike price, and the put option expires worthless, resulting in the premium as profit. This can happen a lot but remember, so long as the stock closes out above the strike price, you don’t buy. Remember that even if the stock does close under the strike price, your breakeven for the trade is $9.60 per share since you have already pocketed the premium.
- No. 3 — Risk Scenario: The stock price falls significantly, and you may be obligated to buy the stock at a higher price than the market value. This is the risk that you take when selling puts. But it’s important to note that you should be selling puts on stocks that you WANT to own. Remember, buying 100 shares of Ford today would cost $1,063. If the stock fell to $9.00, you’d be down $163 on paper as the shareholder. But if you sold puts and had to buy the stock, you’d only be down $60 on paper since you purchased shares at $10.00 and already pocketed the premium.
What Makes This A Good Strategy
There are several reasons to love put selling.
- A Great Way to Generate Income: You receive a premium upfront from the option buyer by selling puts. If the put option expires worthless, you keep the premium as profit.
- Buy Stocks You Love at a Discount: If you think a stock is overvalued but want to own it at a lower price, it gives you a better alternative than traditional “lowball limit” orders requiring a significant margin. Buy the stocks you want to buy, and pick the price you want to pay on a timeframe of your choice.
- Excellent Risk Management: Selling puts involves less risk than buying stocks outright. While there is a risk of being obligated to buy the stock at the strike price if it falls, the premium received helps offset potential losses. Remember, the paper losses of stock ownership will be larger than those of a put-selling strategy.
Today, we learned about put selling with an example of what this strategy would resemble. It’s not an endorsement of Ford Motor Company — it’s just an example of how to trade. I wanted to ensure we had a cheap stock under $15 since a company like Apple would require far more margin in the trade.
I’ll talk about my favorite put strategy and give you a trade that you can immediately put to work on Friday.
Chat soon,
Garrett Baldwin
*This is for informational and educational purposes only. There is an inherent risk in trading, so trade at your own risk.
P.S. 3 Reasons to Be Bullish on Tesla
Shares of Tesla are up over 100% in 2023…
And over 2,800% over the past 10 years…
But there’s still a lot of upside inside Tesla, and a number of ways to play the stock.
And, according to Tesla options trader extraordinaire Lance Ippolito, there are three big reasons to take a closer look at Tesla.
Catalyst No. 1: The Cybertruck Delivery:
Cybertrucks will start being delivered to buyers relatively soon.
And that means all those new deliveries will add a major boost to the number of monthly cars Tesla delivers to consumers.
Catalyst No. 2: Repercussions from unionized workers:
Some sources estimate Ford and GM lost $100 million a week during the UAW strike…
While the strike has ended, the three biggest U.S. automakers are now paying out a lot more to workers.
Tesla does not suffer from a union problem…
Catalyst No. 3: Trading Cycles:
A lot of people don’t know this, but TSLA moves in fairly predictable trading cycles.
By my count, there have been 13 major bull cycles, and we could be on the cusp of the next one.
So If you want to see how I plan to trade Tesla over the next few weeks.
Check Out This Trade Designed Just for Tesla
Market Momentum is GREEN
Momentum is Green with a solid pop today out of the Russell 2000. We’re looking for more money to spill out of the big caps and into small caps to extend the IWM’s rally.
*This is for informational and educational purposes only. There is inherent risk in trading, so trade at your own risk.
