Selling put options can bring a steady stream of income into your brokerage account. Put selling is a strategy suited to a rising stock market. Selling far out-of-the-money puts minimizes the risk that a sold put contract will turn into a big trading loss. The profitability of the strategy should be calculated and compared option trading options.
Selling Put Options
A put option gives the option holder the right to sell the specified stock or security for a predetermined price until a set expiration date. The price of the stock at which the option can be exercised is called the strike price. When you sell the put, you receive a premium from the buyer. You must buy the underlying stock at the strike price if the put holder elects to exercise the contract. You want the stock price to stay above the strike price until the option expires. If this happens, you keep the premium from selling the put with no further obligations.
Covered vs. Naked Puts
You can sell cash secured puts, with cash designated in your account to cover the put if it's exercised. If a sold put has a strike price of $25, you would need to put up $2,500 for each contract sold. You may elect to sell far out-of-the-money puts to avoid the necessity to cash secure the contracts. Far OTM puts have a low likely hood of being exercised. For example, if the stock is at $50 per share and you sell put options with a strike price of $25, the stock would have to decline from $50 all the way below $25 for you to start to lose money on the trade. The trade-off of selling far OTM puts is that the premium received for each contract is less than for puts with higher strike prices.
A trader selling out-of-the-money puts is said to be selling naked or uncovered put options. You will receive the premium for the contracts sold, less the commission paid the broker. For example, with Apple stock at $346 per share, you elect to sell Apple puts with a two month expiration and a $300 strike price. The price of the option is $3.05. You would receive $305 for each contract sold (since each contract represents 100 shares) less the commission of $5 to $10. Your broker would require you to put up a margin deposit of at least 10 percent of the strike price times 100 shares, or $3,000 per contract, plus the premium received. The investment return would be $305 divided by $3,305 or a 9.2 percent return in two months if Apple stock stays above $300 per share.
Brokerage Account Considerations
Naked put selling can only be done in a brokerage account with the appropriate level of option trading privileges. Selling uncovered puts requires level five option trading authorization, the highest level for most brokers. Option trading levels are assigned based on your experience, net worth, and account balance. Stock brokers can require a minimum account equity of $25,000 to $100,000 for level five option trading authorization.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.