I have been doing a lot of research on various investment strategies and one in particularly has caught my eye. Namely, selling put options for income. Selling put options is like selling insurance. You get money upfront from people who are willing to pay a premium to hedge their risk of something bad happening. In this case, that something bad happening is their stock dropping in price.
How does it work?
The buyer of the put option is paying a premium to protect their investment. Say you own 100 shares of Apple Computer (aapl) and the current price on April 12th, 2011 is 332. You want protect your investment from going down. Let’s say you’re worried that Steve Jobs may not survive his health problems or the Japan earthquake may have disrupted Apple’s suppliers or whatever the reason. Buying 1 put option contract (1 contract = 100 shares) may be good way to help protect your investment.
You’ll pay a premium for this for coverage spanning a certain duration (until the expiration date). If you are concerned about something in the near term, you could buy put options that expire in May or June… or, if you want longer term protection, you could go out to a longer expiration (October or even January of next year). Generally, the longer the expiration, the more expensive the put option will be. The other variable to consider is the strike price. At what level are you interested in insuring your investment. If apple is 332 and you’re worried about it going below 300, you could buy a put option with a strike price of 290 (for example). Generally, the lower the strike price (relative to the stock price), the cheaper the option will be b/c the odds are lower that the stock will drop that much further.
The seller of the put option is earning a premium immediately buy agreeing to purchase a stock at a certain price at a certain date in the future. Selling put options is a bullish strategy. The option seller hopes the stock price goes up or stays the same during the term of the option period (until option expiration). Based on the above generalities, a put option seller can make a larger premium by writing (selling) a put in the money (where strike price is higher than the stock price) and long dated (expiring a long time from today)… The put option seller gets the most premium with these types of puts b/c these have the highest probability of getting exercised. On the other hand, a put option seller could sell an option expiring this week (Friday) that is 20% or more out of the money (where strike price is < 20% the current stock price) and receive very little to zero premium for writing this put (because the risk of it being exercised is so low).
Now, who is the smarter investor/trader? The buyer of the put option or the seller? As with most things in life, there are no easy answers. Malcolm Gladwell wrote a very interesting article contrasting two very smart investor/traders (Victor Niederhoffer, Nassim Nicholas Taleb) who each, in certain time frames, made and lost big sums of money. It looks like in the long run, Nassim’s methodology (buying puts) allows him to sleep better at night and wind up with more… Victor’s short-coming may have been his greed buy selling options too far out or too close to the money or in quantities that he really couldn’t afford to lose. See http://www.gladwell.com/2002/2002_04_29_a_blowingup.htm, it’s a great read even if you’ll never buy or sell a put option.
For me, in spite Victor Niederhoffer’s track record, I still like the idea of selling deep out of the money put options with near term (30 days or less) expiration dates on stocks I wouldn’t mind owning but don’t necessarily want to own and having risk management rules that get me out of the positions before any material losses overwhelm my portfolio. I can reduce company specific risk by spreading out my option sales across a handful of different companies. However, I don’t see any clean ways to hedge against some type of major market risk (1987 crash, 911, flash crash, or worse). So, for now, I’ll proceed cautiously and not bet the farm.