How to Make Money Selling Time
Harness the power of put options to rake in a very decent income.
Options have gotten a bad rap. The collapse of the NASDAQ in 2000 humbled many a trader, myself included. Options are touted as a dangerous, complicated to understand, indeed, it has been tagged as a weapon of financial self-destruction.
Options are financial instruments that were designed for a purpose: to hedge one’s stock positions, or to speculate. Within this very wide field, there are permutations to options that allow them to perform a very wide range of functions. This article is about generating income specifically from put options.
First, some very basic information. Options come in two kinds: calls and puts. Both calls and puts are contracts that convey an intangible right, but not an obligation, to either buy or sell stock at a specific price (known as the strike price) by a specific date (the expiration date). Call options grant the right, but not the obligation, to buy stock for a certain price by a certain time. Put options grant the right, but not the obligation, to sell stock at a certain price by a certain time. Within these two domains lie many possibilities.
The beauty of options is that you do not need to own the stock in order to sell options on it. And you can “protect” stock without owning it by establishing an option position when you anticipate a decline in the stock. But this article is about selling put options to generate income.
Options are priced by contracts. Each contract controls 100 shares. Options are priced in increments, and have expiration dates. Options are either bought or sold.
Selling Puts
As stated above, a put grants the right, but not the obligation, to sell the underlying stock at a specific (strike) price by a certain time (expiration).
If you BUY a put option, you are BUYING the right, but not the obligation, to SELL a stock for a contracted price by a certain time. You are in control. You decide what to do.
If you SELL a put option, you are SELLING someone the right, but not the obligation, to SELL the underlying stock for a contracted price by a certain time. In this case, you are obligating yourself to have the underlying stock SOLD to you. You are conveying that right to the buyer of the put option. He holds the reins; he is in control. But you do have the choice to get out of the contract if you wish.
Let’s look at an example. nVIDIA (NVDA) closed Friday, February 11, 2011 at $23.47. It has reported earnings, and has had a very decent run over the past year, and has reached a lofty price level. You think it is either going to go sideways or perhaps down a little. You do not own the stock. You determine that no big surprises are in the offing. The next month’s $20 put fetches 2.1 x 2.5 (bid x ask). When you sell, you sell at the bid, and when you buy, you by at the ask. So, the March $20 put can be sold for $2.10 per contract. For the sake of this article, we’ll assume that we are working with 10 contracts, or 1000 shares. With NVDA’s closing price at $23.47, the $20 strike price is said to be out of the money, in this case, 14.78% out of the money. That means that the stock (NVIDIA) would have to drop by close to 15% before your position is in danger. We’ll look at what that means a bit later. So, let’s see what we’ve done:
Sell to open 10x NVDA March 2011 $20 puts = $.48 x $.50 (bid x ask)
The bid price of $.48 is reflecting the price per share. Since we are talking about 10 contracts which you will recall control 1000 shares, you would multiply $.48 x 1000 to arrive at $480.00. We will dispense with commissions at this point (commissions have become very inexpensive, relatively speaking. At OptionsXpress, for example, the commission for selling 10x of puts as above is $14.95).
But you need to put up some collateral for the privilege of pulling in $480, known as margin. You also must be approved for put selling by your broker. The margin required to sell puts naked (that’s the term, I didn’t make it up, I swear) is typically 30% of the underlying security. This amount varies, depending on the security, but generally runs between 20% and 50%. How does that compute? With NVDA selling at $23.47 per share, 1000 shares represent $23,470.00, and 30% represents $7,041.00. You have just sold some puts that are out of the money by about 15%, expire in one month, and received $480.00 against money placed as collateral in the amount of $7,041.00. Your return is 6.82%. Not bad for a month. The formula for how much money is kept as collateral (margin) is as follows: 30% of the underlying security x100 x number of contracts sold less the premium received. In other words, $23.47 x 100 = $2,347 x 1000 shares = $23,470.00 x 30% = $7,041.00 – $480.00 = $7,521.00. This is your margin, but curiously, the $480.00 you received increases your cash available to spend! Do I have your attention yet?
Collateral (margin) can be computed from mutual funds already at the brokerage house, or cash directly deposited into your account. Remember, you are not restricted to selling only next month’s put options. Generally, the longer time you are allotting your options to “cook,” the higher the premium. Nor do you have to sell 10 contracts. And you can also be selective about your strike prices, depending on your risk tolerance. All strike prices and expiration date information is easily available through your broker or on Yahoo! Finance.
Options expire the third Friday of each month. In this example, the March expiration falls on March 18, 2011. You’ve sold your 10x of NVDA, you’ve taken in $480.00. Now what? Here are the possibilities: NVDA stays around its current price all the way through March 18, 2011 and your options expire. That is the ideal situation. The $480.00 is yours, and your collateral (margin) of $7,041.00 or $6,561.00 (depending on your computation) is released, to be deployed again in whatever way you wish.
Or, NVDA climbs in price, and again your put options expire, and your margin is released.
Or, NVDA goes down in price. OMG! No worries. Your strike price is $20.00. As long as NVDA does not breach that price, you are safe. NVDA has approximately 15% of leeway to jiggle with the market before your position is at risk. NVDA can meander down all the way to $20.25 and you’d still have your put options expire worthless and your margin released. Why did I say $20.25? Because there is a small anomaly in the market that if the underlying security is within $.25 of the strike price at expiration, it could conceivably be exercised against you. Closing out your option simply means buying it back, paying the current ask price, and having your margin released.
Options are not static. They constantly re-price, based on the price action of the underlying security, as well as the time to expiration. In the case of out of the money options, the entire premium is made up of time, and the less time you have until expiration, the faster that time premium erodes. In the case of the NVDA options above, we sold the $20 strike price options, about 15% out of the money, for $.48. The entire $.48 is time premium. The longer you hold onto those puts, the more that time premium erodes, so even if NVDA does nothing between now and March expiration, your $.48 will erode simply by virtue of the passage of time. And that is what you want. You want your put option to expire without any premium in it at all.
You have sold the put, taken in $480.00, glad to have generated close to 7% for one month’s work, and suddenly, NVDA has some bad news and the price craters well below the strike price. In such an event, your put option premium will increase in value (how much depends on a number of factors, including the “Greeks” and volatility, which are the subject of another article). Your choices here are to either close your position by buying back your puts at their current price, or hang on to the position and watch what happens to the price of NVDA. The worst possible outcome is that you are assigned 1000 shares of NVDA at $20.00. Remember that a put option conveys the right, but not the obligation, to sell a stock at a certain price within a certain time frame. In the above example, you SOLD someone that right, and now NVDA has been assigned to you. Why would someone “exercise” his or her right to sell the stock at $20? As long as NVDA stays above $20, there would be no reason to exercise the put at $20, when the market fetches a higher price. But if NVDA’s price decreases substantially, say, to $15, the person who owns those puts (and that contracted right) now has a perfect reason to sell the stock for the $20.
You now are the owner of 1000 shares of NVDA which you bought for $20 (the strike price of your sold puts). The price for the 1000 shares is $20,000.00. The $480.00 you received for selling the puts is yours to keep, no matter what. In a margin account, your margin requirement is usually only a fraction of the total cost, and this fraction depends on the brokerage house and the underlying stock, but for illustration, might be $10,000.00 (50%). In order to generate the original $480.00 in time premium, your margin (collateral) was $7,041.00. Now that you are the proud owner of 1000 shares of NVDA, your collateral is $10,000.00. Not much different. If you sold the puts in order to buy NVDA at a discount, you are now delighted to own a stock you love that you bought “on sale.” You thought it was a great price at $23.47, and at 15% discount is an even better price. That price is further reduced by the $.48 per share less for it, so your break-even price is now $19.52.
Can we do better? Let’s see what happens if we extend the time to expiration. The longer the time to expiration, the higher the premium. With NVDA’s current price $23.47, sell the puts that expire in September 2011. The bid and ask prices for the $20 strike are $1.90 x $1.95. Remember that when you sell, you sell at the bid price, in this case, $1.90. For the same 10 contracts, or 1000 shares, we will be bringing in $1,900.00. Our margin (collateral) will remain the same at $7,041.00. The $1,900.00 in premium that you receive will mitigate your margin and increase your return. The ROI (return on investment) is calculated as $1,900.00/$7,041.00=26.98%.
Admittedly, $1,900.00 is a handsome sum to generate in the next six months, for a relatively small collateral; you put up $7,041.00, you generate $1,900.00. If you keep this position until its expiration in September, you are $1,900.00 richer, and your margin is released. But you don’t have to wait until September. If NVDA rallies between now and then, your put options will decrease substantially in value, and you can then buy back to close your position at the current price, pocket the difference and have your margin released, and move on to the next position.
The beauty of puts is that:
You receive money immediately. The stock can go up, stay the same or even decline, and you still make money. You can buy stock at a discount, sometimes a substantial discount.