A Put is an option contract giving the buyer the right, but not the obligation, to sell or “put” to the seller a specified amount of an underlying security at a designated price for a specified time. Sounds complicated, right? Well, who said making money was easy?
Let’s take a moment and try to understand car insurance instead. I have a car and I have insurance. I’m a simple guy and I can understand that. I buy car insurance for a certain period of time and if I have an accident that totals my car, the insurance company buys it. They give me a check and I go buy another car. Simple. I understand that. On the other hand, if I don’t have an accident then the insurance company takes my money, provides nothing for me financially during the insured period, and then tells me at the end of the policy that I need to renew it and pay them again for another term. I understand that too. Now as long as I don’t have an accident, I keep paying my insurance company and get nothing in return except the comfort of knowing I’m in good hands. My insurance agent has a good gig going there and he’s getting fat on my nickel cause I rarely have a claim.
Now reverse the situation. I want to sell puts. I’m in essence the insurance guy. I’m selling a put option like he sells insurance policies. He’s insuring cars, I’m insuring stock. I guarantee if something happens to the stock someone else buys, I will reimburse them for the loss (it’s what your insurance guys does if you have an accident). For that guarantee the buyer of the put will pay me a fee like we all pay our insurance premiums. If the underlying stock doesn’t fall within a certain time period, I simply pocket the fee and then sell him another put option and pocket that fee too. And now I’m getting fat on someone else’s nickel just like my insurance agent is on mine.
But, you say, if the stock tanks (like my car’s totaled) I have to buy the stock from the put buyer at the agreed upon price even if the price on the open market is lower. And I say that’s true. I’m buying stock that results in an immediate loss. But there in lies the risk. Did you think I was gonna take some guys money without any risk at all?
So what do I do to minimize my risks? First of all I’ll only sell puts on stocks I think are not going to go down and therefore I won’t have to buy the stock and I can keep all those fees to myself. Second I only guarantee a price significantly below the current price so that any initial fall is the risk of the owner of the stock and not me. This is similar to your deduction on your insurance policy. For example, you pay the deductible, or take the first loss, before your insurance policy pays. With these two conditions I reduce the probability of me ever having to buy the stock at a loss. Smart, huh?
Now the last part of this risk reduction is determining how far below the current price will I sell a put. To determine that I use a market indicator developed by John Bollinger called Bollinger Bands. They’re a specific indicator that is calculated using basic college level statistics. Unfortunately a discussion of Bollinger Bands is a little complicated and is going to have to be left for a later post.
Finally, all of the discussion above is predicated upon the idea that I don’t want to end up buying the underlying stock and I only want to collect fees. This is true for this example. But there are other reasons to sell puts, and there are advantages to selling those depending on your investment strategy. Those reasons I will have to leave for another discussion.
Let’s take a moment and try to understand car insurance instead. I have a car and I have insurance. I’m a simple guy and I can understand that. I buy car insurance for a certain period of time and if I have an accident that totals my car, the insurance company buys it. They give me a check and I go buy another car. Simple. I understand that. On the other hand, if I don’t have an accident then the insurance company takes my money, provides nothing for me financially during the insured period, and then tells me at the end of the policy that I need to renew it and pay them again for another term. I understand that too. Now as long as I don’t have an accident, I keep paying my insurance company and get nothing in return except the comfort of knowing I’m in good hands. My insurance agent has a good gig going there and he’s getting fat on my nickel cause I rarely have a claim.
Now reverse the situation. I want to sell puts. I’m in essence the insurance guy. I’m selling a put option like he sells insurance policies. He’s insuring cars, I’m insuring stock. I guarantee if something happens to the stock someone else buys, I will reimburse them for the loss (it’s what your insurance guys does if you have an accident). For that guarantee the buyer of the put will pay me a fee like we all pay our insurance premiums. If the underlying stock doesn’t fall within a certain time period, I simply pocket the fee and then sell him another put option and pocket that fee too. And now I’m getting fat on someone else’s nickel just like my insurance agent is on mine.
But, you say, if the stock tanks (like my car’s totaled) I have to buy the stock from the put buyer at the agreed upon price even if the price on the open market is lower. And I say that’s true. I’m buying stock that results in an immediate loss. But there in lies the risk. Did you think I was gonna take some guys money without any risk at all?
So what do I do to minimize my risks? First of all I’ll only sell puts on stocks I think are not going to go down and therefore I won’t have to buy the stock and I can keep all those fees to myself. Second I only guarantee a price significantly below the current price so that any initial fall is the risk of the owner of the stock and not me. This is similar to your deduction on your insurance policy. For example, you pay the deductible, or take the first loss, before your insurance policy pays. With these two conditions I reduce the probability of me ever having to buy the stock at a loss. Smart, huh?
Now the last part of this risk reduction is determining how far below the current price will I sell a put. To determine that I use a market indicator developed by John Bollinger called Bollinger Bands. They’re a specific indicator that is calculated using basic college level statistics. Unfortunately a discussion of Bollinger Bands is a little complicated and is going to have to be left for a later post.
Finally, all of the discussion above is predicated upon the idea that I don’t want to end up buying the underlying stock and I only want to collect fees. This is true for this example. But there are other reasons to sell puts, and there are advantages to selling those depending on your investment strategy. Those reasons I will have to leave for another discussion.
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