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April 26 2011  / Strategy Article - Selling Stock Options - Put Selling
Why Sell Puts?
Selling Puts As An Investment Strategy

Introduction

Today I received an email from a reader asking the following:

As I'm trying to better understand your thought process and Options in General... tell me I understand, per my example:

Lexmark stock today $37.43

LXK Lexmark Puts,

Currently the May $37 puts are selling for $1.70 Five contracts @ $1.70 = $850.

Stock stays below $37, I get assigned 500 shares at $37 = $18,500  (true cost $18,500 - $850= $17,650) Stock goes past $37, assignment never happens, keep $850

 

Downsides: 

Assigned stock and price continues to fall?

Upsides:  $850 ??

 

What else am I missing?  Is the goal to Sell a put with no hopes of assignment, while gaining a smaller profit from each sale?

 

I am asked this all the time, so I thought I would post it here under the topic of Why Sell Puts? This way, when asked by other readers, I can point them to this article.

 

Many investors cannot understand why I would set up put selling as an major options investing strategy. In fact most investors do not consider stock option selling as "investing". Every week I get emails from readers "complaining" that put selling is not investing. I also always hear that options are "too risky". However understood properly options selling in options investing at its finest. It is very worthwhile for investors to learn what is option trading and how to implement it.

 

However I can understand the comments of these investors. Most have been "raised" on the understanding that investing is buy a stock, mutual fund or ETF, it rises and then it is sold at some time for a profit. For most investors this seems like "true investing". But as we all know, most investors never know when to sell and many buy when the stock is high not low, so the reverse happens.

 

As well many investors point out to me that when I sell puts I have removed myself from making more income should the stock rise in value while I am holding naked puts at a specific strike for a specific amount. Just as in the above email, where the sender says Upsides: $850.00??

But if I feel the stock is in an uptrend I can keep closing my sold puts and sell more puts higher up following the rise in the stock's value so my upside is not actually limited. This is indeed the best of both worlds, stock and option.

 

Their complaints are all valid points, but often they are made by investors who have not taken time to study put selling or options in general as an investing strategy. Done as an options investing strategy, its generates consistent monthly profits that allows for constant compounding of my capital.

 

Consider for a moment earning just 1% a month on a portfolio of $200,000.00. The first month the portfolio earns 2000.00. This means that the next month I now am investing 202,000.00. The second month then my return of 1% is 2020.00.

 

Here is the first year:

Month 1  Earn 2000.00 - Available to invest for next month - 202,000.00

Month 2  Earn 2020.00 - Available to invest for next month - 204,020.00

Month 3  Earn 2040.00 - Available to invest for next month - 206,060.00

Month 4  Earn 2060.00 - Available to invest for next month - 208,120.00

Month 5  Earn 2081.00 - Available to invest for next month - 210,201.00

Month 6  Earn 2102.00 - Available to invest for next month - 212,303.00

Month 7  Earn 2123.00 - Available to invest for next month - 214,426.00

Month 8  Earn 2144.00 - Available to invest for next month - 216,570.00

Month 9  Earn 2165.00 - Available to invest for next month - 218,735.00

Month 10 Earn 2187.00 - Available to invest for next month - 220,922.00

Month 11 Earn 2209.00 - Available to invest for next month - 223,131.00

Month 12 Earn 2231.00 - Available to invest for next month - 225,362.00

 

TOTAL EARNINGS - 25,362.00 = 12.68%

Then think about 10, 20 and 30 years of this type of growth.

 

This is a pretty simplistic example but it describes the process of compounding my earnings through options investing.

The picture I have chosen for this article is of an investor growing his "investments" from a "small plant" because to me, that's what selling naked puts is all about. I plant the seed through selling puts, and each month my "plant" keeps growing "taller".

 

I realize that an investor who buys stocks and sells them when they rise, can easily match my returns and in many cases do better. I'm not arguing that put selling is a must strategy for everyone or that it is a superior investing strategy. What I am saying is that when implemented properly, with clear goals and objectives stock option selling can create steady income in every market condition, offers some protection from a downturn, can get me into a stock at a lower level and most important, I can earn enough over a period of time that I am using other people's capital to pay for my stock when assigned.

 

For me I have been doing naked puts for over 3 decades. I started at a time when options were available only on a handful of stocks and ETFs were not "invented" yet.

 

There are literally hundreds of investing strategies and styles. Whether or not one is more superior to another I wouldn't know and most of the time it depends on the individual investor and their level of comfort when putting their capital at risk through investing. What I do know is that after years of paper trading and working with small positions, I developed a variety of strategies that for me have created consistent small monthly profits which over time has grown my portfolio considerably. It has been good in bull and bear markets.

 

So perhaps to understand "Why Sell Puts" let me take apart the email question and answer it in parts. Read Part 2

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