It is an income strategy by collecting a premium upfront, a form of income, where you are obligated to buy the stock at a certain price called the strike price sometime in the future on or before expiration date when the buyer of the option puts it to you or exercises the option. Your position is called STO, sell to open and the option contract remains open until it expires or closed by BTC, buy to close by you. The buyer of the put option has the right to sell you the stock, called exercising the option, and that is the reason why he or she paid you the premium in the first place.

The buyer of the put option expects the stock to go down below the strike price at which time he or she can put it to you, exercise the option, that is, at the agreed strike price when the market price is well below the strike price or even zero for that matter. If the stock price ends up above the strike price on expiration and also remains above the strike price until expiration you the seller gets to keep the premium you collected and that could be a substantial amount deposited into your account right away when the option is opened, ‘STO’ed. But it remains unrealized in the brokerage account until the option expires or it is closed by you by buying the option back to close, called BTC, buy to close.

The seller has the advantage of selling the time value of the option which mean the seller can buy the option back after a substantial lapse of time at a lower price and pocket the difference if the stock price goes up or remains just about where it was when the option was sold.

However the disadvantage for the seller of the option is that he or she is put in a obligatory position to buy the stock at the strike price on or before expiration, if ever the option is exercised by the buyer. Therefore the seller has to stash away cash to cover the position, all the time until expiration. Otherwise the call becomes “naked” and the brokerage firms will not allow this in the first place to protect the seller from a substantial risk of dealing with the stock plummeting to near zero levels.

Example:

Let us assume you have 200 shares of AAPL which you bought over a period of time and the cost basis if $100 per share. The market price as of May 29th 2015 is $130.28. Looking at July 17th, 2015 put option at the strike price of $125, it is about $1.82 a share. Selling two option contracts that cover 200 shares will give the seller a sum of (200x$1.82) $364 credit immediately. If AAPL does not fall below $125 on or before the expiration date of July 17, 2015 the seller keeps $364 for good.

Pop Quiz

Question No.1: Do you have to have 200 shares of AAPL to open this “Sell” put position STO?

Answer: The selling put option makes it obligatory to buy (not sell). Therefore the answer is “no”. I deliberately tried to check your understanding.

Question No.2 : How do you cover yourself (not get naked)?

Answer: Should the stock fall below $125 on or before July 15 expiration and the buyer exercises his or her option to put to you, you should be in a position to buy all 200 shares of AAPL at $125 a share. This means you have to have $25000 available in your brokerage account. This is called “covering the put option”. The brokerage firm will not allow the STO position (opening the option trade) if $25000 is not available in your account. This cover will have to be maintained until the option is closed or until the expiration date. This does not have to be a disadvantage because the premium collected is giving you an annualized return of 17.5% on your $25,000 investment (200x$1.82/25000x12x100). Where will you get 17.5% ROI (return on investment)?

Question No.3: How can you have the cake and eat it too?

Answer: Suppose you are convinced that AAPL is heading up to $200 a share in the near future based on your homework research. It is time to accumulate AAPL shares every month this way. Let someone pay you premium to sell you AAPL shares at $125 a share, sort of like cash back to sell you a new car. If they can not sell you then you get to keep the premium anyway, a ROI of 17.5%. Alternatively, the premium collected reduces the basis of your existing AAPL stock. Either way you win! It is a powerful strategy to employ every month, or even long term, no doubt, provided you do your homework right in selecting the right underlying stock and the market conditions to execute the option trade on the underlying.