There is so much advice out there when it comes to trading. Oftentimes traders end up gambling by placing low-probability trades in hopes of a large payoff. If you’re going to be consistently profitable, it’s important to think long-term and place high-probability trades while mitigating risk.
Some gurus will promise you a fortune when it comes to using their options trading strategies, however, their teachings often end up costing you money..
If you want to learn how to make additional income without spending too much time studying the stock market, you need to understand why certain options trading strategies can generate a profit consistently.
Check out our breakdown of why selling put options can help you benefit in any market!
How does Options Trading work?
First, let's do a basic overview of how options trading works, and what is a call and put option.
An option is a derivative instrument that is priced based upon the expected movement and price of the underlying security. When you buy a call option, you hold the right to purchase the security at a specific price (known as the exercise price) before it expires.
On the other hand, buying a put option will allow the holder to sell the underlying security at the option exercise price.
What happens if you decide to sell put or call options?
As the seller, you hold an obligation to the option buyer if they choose to exercise their option.
For those selling a call, this means you have an obligation to sell the security at a predetermined price.
For those selling a put, you have an obligation to buy the security at a predetermined price..
Best Practices when Selling Put Options
When it comes to selling put options, what is the best approach? Here are some best practices to keep in mind so that you minimize the risk of this trading strategy:
When selling put options, you should be comfortable owning the underlying security at the predetermined price. This is important because if the counterparty chooses to exercise the option, you will be required to buy all 100 shares of that options contract.
On top of that, you should only place trades if the potential net price paid for the put option's shares is attractive to you.
If you want to make money trading puts options, this is probably the most important principle to keep in mind.Applying these practices to all your trades takes some time, but also requires the right guidance and mentorship.Find out why David Jaffee’s options trading course has successfully trained over 1,500 students.
How to sell put options prudently
Let's say Company X has a newly released product attracting many investors. Their stock is currently trading at $550, and there are many indicators that the price of the stock will rise over the next few years.
One investment / trading strategy would be to buy 100 shares for $55,000, plus commissions and fees.
But what are the financial gains to be made if you choose to sell a put option? Is it better than simply buying 100 shares of Company X right now?
In this example, you can sell a $500 put option expiring in two years and collect $40.
For this option contract, you'll be able to collect $4,000 in options premium (less commission) while being obligated to purchase the security at $500 if the option is assigned.
Since the price of Company X's shares is trading at $550 today, you are selling insurance and actually agreeing to purchase the stock at a ~10% discount from where it’s currently trading, while also receiving an extra ~8% in option premium..
But what if the price of the shares does drop to $500 before the expiry date? In this scenario, if the option is assigned, then you will be obligated to buy the 100 shares at $500.
Remember that you will still keep the premium of $40 per share (or $4,000 per contract). This means that the net price paid for each share will be $460. In total, that's only a net sum of $46,000 and it also represents almost a 17% discount from the current market price of $550.
If you believe $460 per share is an attractive price, then selling this options contract may be a good trade to make.
You'll also have to make sure that you have enough cash available in your account to buy these 100 shares. If you don't, your broker can force you to sell your position in other holdings to finance the cost of buying these shares.
Ideally, the best case scenario would be for the share price to never drop below $500. In this case, the option expires and you'll keep the full premium of $4,000.
One negative aspect of selling options is that, unless you own the shares, you will not be able to participate in the upside gains of the underlying stock.
For example, if Company X appreciates to $650, then your maximum gain will still be $4,000. As an option seller, you will not earn more money if the stock increases in price (although the value of your option will decrease, which will allow you to close out the position early, for a large profit, and allocate capital to another position).Final Thoughts
If you're new to options trading, it’s important to avoid making mistakes. This post is very valuable and will enable you to see what trading mistakes you’re making.
Selling put options has its financial benefits, however, you need to learn how to optimize your trades without taking unnecessary risks.
As an options trading coach with significant experience, David Jaffee teaches his students how to successfully trade options by limiting their losses.
If you want to learn how to win up to ~98% of your trades check out David Jaffee's options trading course and find out why many believe he is one of the best options trading coaches.