How To Sell Puts; Two Very Simple But Effective Strategies

How to Sell Puts: Two Effective Strategies

Aug 22, 2024

Introduction

Selling puts is a powerful options strategy that can generate income and potentially acquire stocks at a discount. This essay will explore two distinct approaches to selling puts, providing real-world examples and expert insights to guide traders in implementing these strategies effectively.

Strategy 1: Waiting for the Target Price

The first strategy involves patience and precision. As renowned options trader Jim Bittman once said, “The key to successful options trading is to have a plan and stick to it.” This approach embodies that principle by waiting for the stock to reach a specific target price before selling puts.

Example: Selling Puts on Apple (AAPL)

Let’s consider Apple (AAPL) trading at $150 per share. A trader might set a target to sell puts when AAPL reaches $140.

1. Wait for AAPL to trade at or near $140.
2. Look for puts with 2-3 months of time premium.
3. Identify the strike price and premium. For instance, the $140 strike put with 2 months to expiration might be trading at $5.00.
4. Place a limit order to sell puts at $5.00 or better.

If filled, the trader receives $500 per contract (each contract represents 100 shares). If AAPL trades below $140 at expiration, shares may be assigned at an effective price of $135 ($140 strike – $5 premium).

Strategy 2: Immediate Action with Adjusted Pricing

The second strategy is for traders who prefer to act immediately rather than wait for a specific price point. Options expert Lawrence McMillan advises, “Sometimes, the best trade is the one you can make now, not the one you hope to make later.”

Example: Selling Puts on Microsoft (MSFT)

Suppose Microsoft (MSFT) is trading at $300, and you’re willing to own shares at $280.

1. Identify the current price of the $280 strike put with 2-3 months to expiration. Let’s say it’s trading at $8.00.
2. Calculate the theoretical price of this put when MSFT reaches $280. Using a Black-Scholes calculator, you might determine it would be around $12.00.
3. Place a limit order to sell the $280 put for $12.00 or better.

If filled, you receive $1,200 per contract. If MSFT is below $280 at expiration, you may be assigned shares at an effective price of $268 ($280 strike – $12 premium).

Mass Psychology and Put Selling

Understanding market sentiment is crucial when selling puts. Behavioral finance expert Richard Thaler notes, “The combination of loss aversion with mindless choosing implies that if an option is designated as the ‘default,’ it will attract a large market share.”

This insight is particularly relevant when selling puts during market downturns. As bearish sentiment rises, put premiums often increase, providing better opportunities for put sellers.

Example: Selling Puts During Market Corrections

During the COVID-19 market crash in March 2020, the CBOE Volatility Index (VIX) spiked above 80, indicating extreme fear. At this time, put premiums were exceptionally high.

Consider the S&P 500 ETF (SPY) trading at $240, down from its pre-crash high of $340. A trader might have sold the $220 strike put expiring in 2 months for $20, an unusually high premium due to market fear.

If SPY remained above $220 at expiration, the trader would keep the entire $2,000 premium per contract. If assigned, the effective purchase price would be $200 ($220 strike – $20 premium), a significant discount to pre-crash levels.

Risk Management in Put Selling

While put selling can be profitable, it’s not without risks. Options strategist Sheldon Natenberg emphasizes, “The most important characteristic of a successful trader is discipline – the ability to consistently follow your trading rules.”

Key risk management principles for put sellers include:

1. Only sell puts on stocks you’re willing to own.
2. Ensure you have sufficient capital to cover potential assignments.
3. Diversify your put-selling activities across different stocks and sectors.
4. Consider using stop-loss orders to limit potential losses.

Combining Put Selling with Technical Analysis

Integrating technical analysis can enhance put-selling strategies. Legendary trader John Bollinger, creator of Bollinger Bands, suggests, “Tags of the lower Bollinger Band are often good places to buy a stock.”

Example: Using Bollinger Bands for Put Selling

Imagine Amazon (AMZN) trading at $3,000, with its lower Bollinger Band at $2,800.

1. Wait for AMZN to approach or touch the lower Bollinger Band.
2. Sell puts at or slightly below this level, such as the $2,750 strike.
3. If AMZN bounces off the lower band as expected, the puts are likely to expire worthless, allowing you to keep the premium.

This approach combines technical analysis with options strategies to potentially improve outcomes.

Conclusion

Selling puts can be a lucrative strategy when implemented with careful planning and risk management. By understanding market dynamics, utilizing technical analysis, and applying insights from behavioral finance, traders can enhance their put-selling strategies. Whether waiting for specific price targets or acting immediately with adjusted pricing, the key to success lies in disciplined execution and continuous learning.

As options expert Lawrence McMillan reminds us, “In options trading, as in life, it’s not about being right all the time. It’s about being right more often than you’re wrong, and managing your risk when you are wrong.” By following the strategies and principles outlined in this essay, traders can work towards achieving this balance in their put-selling endeavors.