Getting down to the basics of selling covered puts really helps the options trader conceptualize the risks and reward profile behind the trade.
The big risk for the seller of covered puts comes down to this:
If the buyer of a put option has the option to put their shares on someone else, then the seller of a put option is risking this possibility.
Remember (like I explained in my Options for Beginners post) that a put buyer is betting that a stock will go down. So if the stock does go down, and the put option goes “in the money” and is profitable, then the put option seller will have to buy these shares. It will be at a loss compared to current stock price, otherwise the option buyer wouldn’t want to exercise it.
Say I know the financials of a Pet Food stock, trading right now at $12, and I know they have a rock solid balance sheet with low debt. Say that at $11, their P/E ratio is a bargain and I’d be happy owning those shares.
Well, instead of buying the stock outright, I could also sell a put option to collect premiums.
- If the stock drops to $11, which is where I consider the stock a bargain anyways, then I have to buy the stock AND I get to keep the premiums for selling the put.
- If the stock continues to trade flat at around $12 or doesn’t dip below $11, then the put option I sold becomes worthless and I get to keep that premium. Then I can turn around and sell more puts on the stock to collect more premium or eventually get assigned (having to buy the stock) if future puts get exercised.
- In the case I’m selling a put option with a strike price of $11, I’m risking that I’d have to buy 100 shares of the stock at $11. That means I’m risking $1,100 to make this trade.
Depending on the strike price of the puts you sell, or the duration of the contract, or the sentiment surrounding the stock– selling these puts can be pretty profitable, or not.
Generally I like to take the premium offered by selling a put, compare it to what I’d have to risk, and calculate the CAGR return to decide if it’s worth my while or not. I like to shoot for at least 12% CAGR returns, and this is key– it needs to be a stock I’m happy owning through tough times.
Here’s an example.
- If the $11 put option for the Pet Food stock can be sold for $0.15, then that’s a 1.3% return ($0.15 / $11). If it’s a 7 day contract (technical term: 7 days to expiration), then a 1.3% return in one week is really good.
- Multiplying 1.3% by 52 (52 weeks in a year) is 70.9%, which is a rough estimate of the yearly return and something every investor should dream of.
Now, the logistics of this are as follows. A put contract is an obligation to purchase 100 shares.
So a $0.15 premium for selling 1 put option means receiving $15 when you sell 1 contract (100 x $0.15). Again, you risk $1,100 (100 x $11 strike price).
The Two Major Risks of Selling Covered Puts
Now there’s two major risks with this strategy.
- The stock price for Pet Food stock could keep going up, in which case you keep the premium but miss out on the gains if you would’ve just bought the stock outright.
- The stock price for Pet Food stock could dip much lower than $11 and you’d be stuck with a loss.
But here’s how I look at these risks, and don’t really consider them great risks if you have the right mindset and strategy.
RISK #1 – Capping your upside to just the premiums received is a drag, but if you’ve calculated the CAGR return you’re happy earning on your trades (such as 12%+ or something), then really you shouldn’t be upset about it.
During an aggressive bull market, selling put options like this could likely mean underperforming the market for a while. But every strategy has times where it underperforms and outperforms, and if you’re happy with the ups and downs of a strategy with how it relates with your goals for the money invested, then you should be happy.
I know… the fear of missing out is always great, and can be tough to deal with. But there’ll always be trades you miss out on, stocks you miss out on, opportunities you miss out on in your life. Focusing on what you don’t have instead of what you do is a dangerous proposition, not just in investing but in life as well.
The risk is that if you underperform consistently with a strategy like this, then you should take an honest look at what you’re doing and realize something’s probaly wrong.
But constantly lamenting the gains you missed on a stock with a strategy that’s structured to have this happen will torture you, which is why the mindset is so important.
Having huge returns is nice, but if we’re real it’s not a reliably consistent plan.
If I’m getting great returns already, and with little risk such as by selling puts, and it’s consistently happening for us– well I really like the sound of a strategy like that.
RISK #2 – The risk of unlimited downside is real. Having to buy a falling stock can be dangerous as any falling knife investor will tell you.
However, this risk is real whether you are selling put options or buying and holding a stock. So if you’re selling puts on stocks that you’d be happy buying anyways, which is what I said is an important part of a strategy like this, then this downside risk isn’t really that much more of a risk at all.
This is the part that gets lost on many put option sellers, who think of this type of options trading as really just a bullish bet on a stock going up and not so much as a win-win scenario.
An options trader might tell you that the stock going down means a loss for your sold put options.
But I look at it this way: if you don’t sell the stock at a loss, then the trade wasn’t a loss, and you’re not locking that loss in.
If you’re really right about the company– it’s a great business with great opportunities for long term profits and growth— then the trade should turn around eventually. As long as you hold long enough for it to materialize.
That’s the competitive advantage you can have using an options strategy like this, and turns you from a speculator who’s guessing on the direction of a stock into an investor who’s using a beautiful feature of options into your advantage.
One last caveat about this…
Selling Cash Covered Puts vs. Naked Puts
To make a trade such as selling a put option, you’re required to risk enough money to buy the 100 shares in case the contract is exercised. Depending on the type of brokerage account you have (cash account vs margin account), you either need enough collateral to cover the margin to buy the stocks or have enough cash to buy all 100 shares.
I highly recommend, and personally only use, cash in my account to cover my puts. This is called selling covered puts, whereas just having enough margin or buying power for the trade is commonly referred to as selling naked puts.
It’s really the only way to really ensure that you can keep the competitive advantage I talked about above, where you’re willing to hold for the long term if the trade goes south, and mitigate a lot of the downside risk that comes with this strategy.
When you use margin, you can frequently get a situation that’s called a margin call, and that’s a profit killer. A margin call happens on stocks that are falling. The brokerage will either ask you to deposit more collateral to keep your position alive, or just close your position outright if it doesn’t look like you have enough cash in your account to cover these new losses. It’s not that uncommon for a brokerage to just liquidate your positions when a trade like this goes south, which locks in your losses on a stock that you would’ve wanted to keep.
It’s also hard to manage a portfolio when you make lots of trades like this, and it can take just one market crash to erase all of the gains you’ve spent months to accumulate when you sell options on margin.
I know it’s really easy to get sucked in to using margin to sell options, and can seem like free money, but please understand that this is exactly how a lot of people get wiped out.
When you’re not properly accounting for the major risks behind options, you’re likely to get burned eventually.
Keep to what you can rely on as an investor, and that’s building your wealth slowly over time as companies continue to grow and your money continues to create compound interest.