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If you want to understand how to buy stocks at a sizable discount AND get paid for doing so, learn how to sell put options. In this article, we’ll help you get started with this simple but powerful strategy.
If you missed our article on buying put options, you can check it out here.
When you enter into an option contract as a seller, you are essentially providing insurance for the contract buyer against a loss in stock holdings by promising to buy shares from the put option buyer whenever they choose to sell them (within a limited timeframe). The put buyer pays a premium up front in exchange for this insurance.
This may seem like a terrible deal for the option seller! Put sellers are promising to buy shares from the put buyer whenever the put buyer chooses to sell. However, we have to remember that the put seller is paid a premium, or some cash up front, for taking on that obligation.
Let’s walk through an example to see how this works.
XYZ stock is trading for $50 a share. You sell a put with an agreement to buy 100 shares at $47 per share from the option buyer at any time in the next month. In compensation for this agreement, you collect $1.00 per share, or $100 in total.
In taking part in this transaction, you have promised to buy 100 shares of XYZ stock at a price of $47 per share should the put buyer choose to exercise the contract before the expiration. When you enter into this trade, the broker will hold $4,600. This number comes from the $47 per share less the $1.00 in premium collected, times 100 shares.
This is what a short put looks like in graphical form:
One month later, XYZ stock increases in value from $50 to $55 a share. The put buyer will now make a greater profit by selling the shares in the open market for $55 a share instead of using the option contract to sell the shares to you for $47 a share, so the put option you sold becomes worthless, which is good for the option seller.
As the put seller, however, you already collected a $100 premium ($1 for each of the 100 shares) and can walk away with that profit.
It’s true that in this scenario, you would have made more money by investing directly in the stock at the original retail price instead of selling the put option. If you had bought 100 shares of stock at $50 each, you would have earned $500 total, instead of the $100 premium.
However, doing so would have required more upfront capital ($5,000 vs. $4,600). It would also have required you to risk your $5,000 initial investment. At the beginning of the month, you don’t know whether the stock will increase or decrease in value; buying it is a 50/50 bet. Selling the put option, however, has upwards of a 70% probability of making positive returns.
Think of stock returns as normally distributed where 68% of returns fall within one standard deviation from the mean. When selling puts, you make a profit as long as the stock price stays above minus one standard deviation.
This is what it looks like on a bell curve:
The blue lines represent one standard deviation, where 68% of all stock returns fall. The green shaded area represents all the stock prices where selling puts would be profitable, which is about 70% of the area under the curve. Don’t worry if you don’t get this now, we’ll have future posts covering this topic.
One month later, XYZ stock is trading for $45 a share. The put option buyer is now better off using the option contract to sell 100 shares of stock to you at the agreed upon price of $47 a share, rather than taking the $45 share price in the open market.
You still collect the $1.00 per share premium (or $100 total), and fulfil your end of the contract by buying 100 shares of XYZ stock at a price of $47 per share. When it’s all said and done, you (the put seller) now own the stock for an effective price of $47 less the $1.00 of premium collects, or $46 per share.
In this scenario, it’s true that you are buying stocks for $1/share more than they are currently worth, for a loss of $100. However, you are also buying the stock at an 8% discount from where it was trading when the transaction was first initiated. Furthermore, if you had just bought shares at $50 outright, you would have lost $500!
Typically if you want to buy a stock, you would pay the market price.
Now, we see that instead of buying stocks at the current market price, we can always just sell puts to buy at a cheaper price, while getting paid to wait.
If you are willing to buy 100 shares of stock, it is a win-win scenario for you. When selling puts, if the stock goes up, sideways, or down a little bit, you collect some extra cash through the option premium because you merely wanted to buy shares of stock at a discount. If the stock ends up going down, you get to buy shares that you wanted anyway, but at a discount.
Just buying a stock has 50/50 odds of making any money. Selling put options, however, has upwards of a 70% probability of profit AND less risk than just buying stock outright.
If you like the sound of this strategy, check out how you can put it into practice at Tastyworks!
Selling puts is the same as promising to buy 100 shares of stock at an agreed upon price at any time before expiration. If you want to buy a stock, this is a great way to increase your probability of profit and reduce risk.
If this explanation of selling puts: how to buy stocks at a discount was at all helpful, let us know in the comment section below!
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