- 1 Six reasons to sell put options
- 2 Part I – Why Sell Naked Puts vs Put Spreads (or other things)
- 3 Part II – execution
- 4 Conclusion
- 5 faqs
Six reasons to sell put options
(Plus How To and When To sell)
How to Trade Options Series: selling put options
Part I – Why Sell Naked Puts vs Put Spreads (or other things)
1&2) Risk Reward of selling puts is superior to and safe as Covered Calls
Options positions list: All but one (recently opened) short options (all puts) are in profit. All long option positions (mostly calls) are in Loss. From an actual account.
How to trade short puts. Contrary to popular belief short puts are not that risky. Most people think that short puts are high risk and covered calls are low risk. But here’s the truth – they are functionally equivalent. Options have this structure to create synthetic positions. A short put is also a synthetic covered call. Here is the illustration.
June 288 buy/write aka covered call for SPY. This has a flat line of $1000 profit at expiry from $288 and above. From that point it goes down linearly with the price of SPY. Breakeven would be at $276.50, reflecting the premium received for the short call. Most people would think this is a good conservative trade because profit is protected down well below the current price.
$288 short put P/L graph.
Comparing the two, we see that the short put has a superior R/R to the covered call. Max upside is $1245 vs $1153 – a sweet 8% increase. It also helps the risk side as well, with B/E point at $275.55. The reason for this is the same as the other – the premium received for the short option is the downside protection. Since the put receives a higher premium (in this case, but not always), risk is proportionally lower. Risk is a bit harder to measure, but technically, we could say that risk is 0.3% less. This is the difference in absolute price between the two break-even points, though, and no one would measure risk on the SPY over 3 months as going to zero.
This is during the Coronavirus market stress period, so risk is definitely higher. SPY could easily go down, but that’s also why the premiums are higher. To be very clear – I’m not saying to sell puts on SPY. In general, the tail risk is too high for this instrument, especially with Implied Volatility generally below 10%. That’s a very small premium for potentially enormous tail risk.
For example, selling $300 puts on SPY for June expiry in February before Covid-19. Here’s the result:
That’s not to say I wouldn’t ever sell a put on SPY, but it’s probably going to be a ratio frontspread. And not to hold for long, even overnight.
3) Better than put spreads
Many people will caution against puts because losses are theoretically limited only by the total stock price. Technically true, but then they suggest the put spread. At first blush these look great – after all, if you sell a GOOG put spread for $5, most of the time you’ll win. Margins are way lower. You can sell one near the money for $2.20 usually, or far out of the money (.2 deltas for the short strike) for $0.80, if you can leg in really well. The mid-point is often achievable with GOOG, but more likely you’ll get 70cents for your spread. This leaves $4.30 in risk, left to expiry. Flipping out when the short strike hits the money (a common technique – meaning closing when GOOG drops to $1315 here) would get you out for $2.30-$2.60 depending on how nimble you are, how close it is to expiry and so forth. That’s a loss of $1.70 or 240%. Not very enticing for me, but I would never sell puts on GOOG. Sounds like a quick way to get REKT!
Aside from slippage and spreads, put spreads are unappealing because of the volatility skew. Lower strikes have higher relative costs, or Implied Volatility for most instruments. This is a put chain for SPY (at $288.25) a week out. Notice how the pink numbers get larger going down. Implied Volatility (relative price) rises as the strikes get lower. This is because the market fears crashes and charges a premium for them. The calls do the same. Unfortunately, this means that selling higher strike options and buying lower strike options works against you. Notice how the 297 and 279 strikes – both are 8 away from the underlying – have ginormous differences in Time Value. Time value is premium – it’s what you’re trying to collect on this trade.
As a side note – SPY option chains are really the best for this kind of studying. In trying to understand the normal reactions of options, the chains are very clean – quickly and appropriately responsive to changes in the underlying, extremely tight spreads (often .01), and with volatility spread throughout time and price in a very even manner. So to explain how options work in ideal liquidity environments – look at SPY chains, especially nearer expiries and close to the money strikes.
A $5 bull call spread at 290/5 (1.50 Out of the Money) costs 2.16. A Bear Put spread 287/2 (the equivalent below the money using puts, betting on a decline) costs only 1.55. Put spreads are great when you’re betting on the downside. They suck when you’re betting on the upside. Naked puts beat them hands-down. The risk, of course, is the occasional pullback. If it’s severe, then losses can be large. On the other hand, a far more frequent moderate pullback can leave a naked put in profit with the short spread in a loss. In the 1.55 spread, the naked put sells for 4.22 – an additional 2.67 of downside protection! If price volatility is low and/or absolute price is below $20, then selling naked puts (a bull strategy) is a far better method.
Takeaway rule: Spreads that bet on a downside move (aka bear spreads) are far superior to spreads betting on the upside because of these mechanics. The corollary – naked options betting on the upside (long calls or short puts) are superior to spreads betting on the upside, though the advantage has some major risk considerations here for short puts.
4) Perfect way to enter a position
Most investors enter positions by buying the stock they are interested in. While this direct route is easy, selling puts on the stock is vastly superior. Let’s look at the most sensible situation to do so – an ultra-high volatility stock like NFLX. Here’s the put chain 5 weeks out with NFLX trading at $438. Purple is ITM and Black is OTM. So purpled options (above) have Time Value (premium) + Intrinsic Value (value if settled now = strike – NFLX price). Black options are Out of the Money, so have only Time Value.
If you want to buy NFLX, but only at a certain price – say 400 – then sell 400 puts until you get assigned (automatically buying the stock for the strike price). If you don’t mind owning NFLX, but are okay with just collecting premium, then sell the ATM options at 435 or 440. If you really want to get in, then sell ITM puts at 470 or so. This gives downside protection of 11.68 – the premium received – before P turns to L. It also gives the possibility of capturing a solid share of NFLX upside, which is the reason to want to be in the stock anyway. So, if it outruns your strike, then hey – you made $3735 per contract.
Here’s how to beef those trades up, potentially quite a bit. NFLX is volatile, so let’s look at our
chart first. Support looks good at 400 – that’s a nice looking V with a decent wick at the bottom to 395. That’s a BIG way below 438, the current price. So let’s look at some put charts to set some best-case R/R targets for selling.
This the 420 contract (still 5 weeks out). The contract peaked at 36.93. The line shows a multi-day high. That’s a decent target. Drop it a bit to cover the spread and increase the chance of hitting it (this will only happen during a drawdown), and we enter a sell for 34.25 or so. Make it a GTC (Good Till Cancel order) or a Good Till Day order because this won’t trigger until NFLX goes down quite a bit. It’s a good idea to enter a GTD order that expires before earnings, as these can bring pretty massive moves. In fact, it’s generally a bad idea to own options that expire after the next earnings date. Sure, you get a lot higher premium, but earnings can make stocks move a LOT. Earnings reports are always the source of the highest moves and FAANG stocks are notorious for blowout moves post-earnings. It seems to be some kind of competition.
The next piece of this puzzle is Implied Volatility. IV goes up really, really fast during a market crash. IV is the cost of the puts in terms of premium – relative of the strike distance from the underlying price. The further from the ticker price, the smaller the premium – an absolute rule of options. The rule is: if you’re selling puts, go back in time and sell at max volatility. (Or just go back and buy Bitcoin in 2011.) The realistic way is to watch the markets during a drawdown, then sell on the second bounce above the lows. Honestly, I don’t like NFLX. It’s way to movey for me. Institutionals bat this weird stock around like a superball playing some games with it. It’s got the worst fundamentals of the FAANGs, imo.
The method above of presetting orders to trigger on a market downdraft is pretty good if you’re patient. The R/R works well, but you need a lot of potential targets. Use OCO (one cancels other) orders and put in a whole bunch of sells at technically selected targets based on S/R. You can extend these to cross multiple tickers, of course. This will dramatically increase your likelihood of fills.
One of the cool things about this system is that you’ll be targeting sells during times of high volatility. When the market does calm down, volatility can collapse very, very fast. This means that NFLX can go a decent distance below the price it was at when you sold (not the strike price) and still leave you in profit. Meaning you have a sell in for 400 puts at 39. NFLX plunges from 440 to 410, triggering your ask as it passes 420. IV is an eye-watering 90%. As NFLX bounces down to 395, it looks pretty painful, to be sure. But it bounces back to 410, where it settles. By the next day, IV has dropped to 50% or so. Your options are now at $22, even though NFLX is lower than where you sold your puts at!
Okay, to be honest – the spreads won’t let something like that work out in actuality. Optimal scenarios are unlikely, but it does show how using the IV pump and having the stones and technical analysis skills can hugely increase your edge. Most traders try to sell puts as the market stands. But it makes much more sense to sell them during big down moves, especially after a deep bounce.
5. Better returns than dividends.
Let’s say we want to get into a nice dividend stock. I like Enbridge – it’s an endpoint energy provider in Canada with a strong, well-diversified customer base. I’ve done well selling puts on it, but was originally looking to take a long-term, sleepy dividend collecting position. It’s the largest energy supplier in North America and it’s a solid dividend Aristocrat (increasing absolute dividends every year for 25 years.) It got put down by the Covid crisis, but wrongly so. ENB isn’t punished particularly by low oil costs. It’s a middleman, so it’s decline in revenue due to lowered prices is matched by its decline in costs for the same reason. Unless people stop using heating oil, it’s a pretty safe bet.
If you want to collect dividends on this blue chipper, then I suggest selling puts instead. Looking past October, the spreads are wide to wider, so let’s keep it within 6 months. Here’s the OCT chain:
I’m not so keen on owning stocks long-term. I see put premiums as an improved surrogate over dividend collection. I know the div payout is .56 twice between now and October. So I want to make at least $1.12, but preferably more, with less risk. ENB is at 32.14, so the 30 puts at 2.55 are pretty enticing.
I can sell at 2.65 very likely. I’ve found putting in an ask at just a bit below the ask – 2.75 here – will trigger the MM-bot to buy your puts just to clear them out of its way. If you don’t have a big order, that is. So you can beat the mid-point price, just by having low size and plopping it in the Market Makers way. Then wait for a while. If it doesn’t trigger within 15 minutes, drop it .05 and repeat until it triggers or you don’t like the price anymore. If we don’t trigger, then we use the above technique – find a high for the option in the past 2 weeks and set a GTC order 5-10% below that price. Set it in an OCO set of orders so we don’t get stuffed full of puts on a downdraft, and let it ride. The OCO will cancel all other orders in the group – this allows to keep open many possibilities for selling puts on a decliner, but protects from selling too many and having a huge drawdown.
If we’re filled, notice that the risk is substantially lower than buying the stock and the reward is probably higher. If the stock doesn’t move or stays range-bound, then the reward for owning it is the dividend. We’re subject to the fluctuations in price then. If we’re short the puts, then reward is the put premium – more than double the dividend payout. We can even get exposure to the stock price simply by selling ITM puts. This increases potential reward – if we think the stock will probably rise.
However, be careful. Puts include additional premium to the downside to cross dividends. That’s because stocks drop after decent size (>.30) dividend payouts. This is the market’s way of preventing ‘dividend capture’: where someone buys the stock the before ex-div, then sells it first thing in the morning. You may get assigned
6) Fantastic ROI.
Look at this info box:
That’s for a NOV 65 put on ATVI (Activision, a high-flyer video game manufacturer). The cost of the put was 4.5 ATVI was trading at $73.02 May 11. The put was 193 days out. Six months, give or take. There are different ways to calculate the ‘investment’ for a ROI calculation on puts. One way is to take the price of the ticker X 100 for each contract. That would give $7302 for the investment. The return is 6% absolute or 12% annualized. (The numbers are approximate to make the example easier to follow).
But there is no way this stock is going to zero. A 50% drawdown is feasible, but unlikely. Though it has happened to ATVI. I would never make this trade, tbh. It’s just an example.
A numbers approach to calculate ROI is to use the margin required. This trade uses 1834 of margin. However, 450 of that comes from the put sale. So the out of account margin is 1384. ROI is 450/1384 = 32% in absolute terms or 64% annualized.
If you are smart about selling puts, the returns are phenomenal! That’s the takeaway. You can also blow up your account with a long-tail event by being fully margined, so don’t do that. Also, margin will go up dramatically when the stock crashes. However, it will decline as the stock rises and as the option value declines from time decay.
Margin is usually calculated on options as .2P+OP-OTM = 20% of the stock price PLUS option premium MINUS out of the money amount.
Part II – execution
- Stock Selection for selling puts
- Option expiry lengths
- Multivariate entry targets – OCO orders
1. Stock Selection for selling put options
Method 1 – Run a scan on Finviz. Try this one. Chart it out and look for an uptrend with a pullback.
Method 2 – Pick a dividend paying, optionable stock you like. Here’s one play I have right now – rather long-term. The puts expire in 01/22. I somewhat regret that length, since the premium to dividend ratio is lower than a nine month out premium.
This ticker is GEO. It’s a prison REIT, so I had some ethical qualms about hitting it, but it pushed ALL the right buttons, so I went ahead.
First, on the ethics. Prison Reits basically own private, corporate prison buildings. I have an ethical disagreement with private prisons, based on the massive incarceration rate in the US – the highest in the world, and probably the highest of all time, anywhere. Now, to be clear, many countries have simply killed dissidents or tortured them into silence, which is way worse. Stalin and Mao were monsters, imo. However, the prison industrial complex is known to have many lobbyists trying to get laws and punishments put on the books simply to raise incarceration rates. It’s a despicable business model that preys on human suffering. I would be happy to lose this trade totally to see such places closed down. I doubt I’ll get my wish, though, which is why I invested.
Secondly, selling naked puts on a ticker in no way benefits the underlying business. In fact, neither does buying the stock, particularly. When you buy a stock, the other side investor gets the money. Only in IPO (or secondary sale – a very rare situation) does the company get it. Maybe it’s a rationalization, but there it is.
At any rate, this REIT has a perfect client in the US government. The stock got badly beaten down in the Corona Virus drawdown. This happened only due to the general collapse, which hit REIT’s especially hard. In the case of retail – that made sense. Brick and mortar retail will get crushed in the panic. However, this is in a completely different area. The fundamentals do not warrant a decline. It should return to its former price in slow order. Even if it doesn’t, here’s my option:
Remember, the price is $11.50 or so, roughly the price where I entered the trade. So, I have a huge 13% downside before it even goes Into the Money. (For puts this means the price is below the put strike price.) But I still have $3.09 of downside from there before it loses money. And one of the nice things about high volatility puts on low-priced stocks – when the stock goes down a lot, the put doesn’t necessarily increase that much. That’s because option prices are typically a reflection of the underlying price. One way to look at it – an option’s premium can NEVER be greater than the price of the underlying. It’s impossible because that situation represents a risk-free trade.
Meaning: if you can sell a put for $6 on a $5 stock, you cannot lose because the expiry value of a put on a stock at $0 is $5. This means that option premiums are always proportional to the price. This will be true across strikes and expiries. Obviously, other factors like earnings, dividends and so forth will cause differentials between put and call or across expiries.
- Instrument Selection. GEO fits the stock selection criteria very well.
- It has a high, stable dividend of 16% forward looking.
- Recent reversal from pullback and possibly second, higher reversal.
- The pullback is based on a market reaction, not underlying stock fundamentals – big plus.
- The put strike is well below the stock price.
- Put price is double the dividend.
2. Option Expiry lengths for short puts
This is a complex bag. As we go further out, spreads increase and liquidity drops – which is saying somewhat the same thing. So we need to establish our max length out based on liquidity. Spreads over 20% of the option bid premium are questionable – above 50% are probably not worth thinking about. Move closer.
Next we analyze the premium vs dividend payout, setting a reasonable target. Minimum target is 1:1, but I recommend 2:1. Remember you are giving up stock price upside (at least selling OTM options), so get compensated with more premium. Target stocks should really pay dividends, and stable ones, for a number of reasons. Dividends should be 5% or more.
Next we look at ticker price and volatility. Higher priced tickers and higher volatility both work to shorten expiry duration. Excessive volatility is best avoided – who knows where NFLX will go next. Nosebleed prices are best avoided too. How much can AMZN drop in two weeks.
3. Multiple sell orders on your puts with One Cancel Other orders
The method I suggest is to develop a target list of stocks you wouldn’t mind owning if you get assigned. Pick your target strike (how much are you willing to pay?) Pick your target expiry time – generally 6 months to one year. Target: can you get double the option premium vs the dividend for a strike that is 15% OTM?
Lookback at the stock chart for 1-2 years. What are the support points? Target an option price for the stock hitting those points by adjusting the current mid-price using the deltas.
- XYZ trades at $100, with support at $90. Difference is $10.
- Puts at 9 months out are $4.50 with delta of .32.
- .32 X $10 = $3.20
- $3.2 + $4.5 = $7.7
Put in OCO (one cancels other) orders for 10 strikes / expiries on XYZ puts. When XYZ declines enough, especially quickly, there is a decent chance of selling your puts. You will only sell one order because you have put in the OCO order to cancel all other orders.
Enhancement: use a trailing stop (not recommended). A trailing stop triggers or activates the order when the XYZ put crosses a certain price (the stop). In the above example, you would set your stop at $7.7 with a $0.5 trail, for example. If the option price goes up, the trail level goes up with it remaining $0.5 behind it. If the option price drops, the trailing price does NOT drop, but executes the sale when it drops by $.5 from the highest price. The lowest price you would get would be $7.20, but it could be much higher.
WARNING: Don’t use a stop with options unless the option prices are VERY liquid. They should work on SPY for example, near the money. However, that far out, options are illiquid, even on SPY. Much more so on everything else. Also, be very clear that you have your settings right, so that the option price is set to the last price, not the bid. Be warned that stops behave unpredictably for options.
Warning: see here for a problem I had with this system.
4. Risks of selling put options
The biggest risk, by far, is a crash in the stock price. This is why lower priced stocks are great. Often dividends are higher in percentage terms. Crashes have a limited downside. Premiums can be MUCH higher relative to the stock price. On the negative, expiries typically need to be further out. However, a strong move up will drop the price of the put significantly and you may be able to close the trade out for 10-20% of your original receipts.
The second risk is assignment. If the stock drops below the strike and the premium goes to zero, you may be assigned. Since you liked the dividend already, this shouldn’t be too painful. Another reason to use dividend stocks.
To sum it up: selling puts is a very good strategy. It’s much safer than most people realize and has high flexibility. If you want to own the stock already, then you can’t really lose. Either you make premium selling a put on a stock that rises, or you buy the stock for a better price than it’s currently at and get to hold it.
Returns, even for Out of the Money puts, can be up to 100% of the margin posted – though actual risk is higher and depends on the volatility of the stock. On well-selected stocks, that have just dropped to solid support, and have a strong dividend record, short puts is a low to moderate risk, high return trade. Many professionals do this trade, and you should learn how so you can add it to your arsenal.
How do you sell naked puts?
You need a margin account first – or a fair amount of capital. Then you can pick stocks with a good profile (covered in this article), especially ones you wouldn’t mind owning. Enter an ask price or sell at the bid to immediately execute. Remember – each contract is 100 shares of stock, so tread lightly at first.
When should I sell my puts?
Before you buy them. That sounds funny, but it’s actually statistically accurate. Options are very likely to decline in price over time, so it generally makes sense to short them, then buy back later, or allow them to expire worthless. Sometimes you may want to be assigned (buy the stock), too.
What are the risks of selling put options?
Market crash. And see this.