What is Put Selling? How Risky is it?
Some people may have heard about a strategy called selling naked puts. The first thing that comes to their minds is, puts must be risky because they are stock optons. Others will use it regularly to create a consistant income from the market.
So what exactly are naked puts and are they dangerous. When you sell a put you give another investor the right to sell a specific stock at a certain price before an expiration date. For exampe if you sell the $30 put on stock XYZ you would get some money up front, but you would also be obligated to buy the stock at $30 should the buyer of the option decided to exercise their right.
That means if the stock drops all the way to zero you could be forced to buy a worthless security for $30.
Because of that selling puts can definately be dangerous. In fact this is one of the only strategies in the stock market that you have the potential to lose more money on one trade then you even have in your account.
So, why do people still use this strategy regularly? Well if used properly it can actually be safer than buying a stock.
Let me explain; say I find a stock that is trading at $40. This is a dividend paying stock and is a fundamentally strong company. I could decide to get into the position and risk $40 or I can sell the $35 put make $3 up front and then not be obligated to buy it as long as it stays above $35.
The great thing is that as long as I keep enough cash lying around to get into the position if I have to, the only thing I am risking is getting into a position I already wanted to get into. So if I bought the stock and it goes down to say $34 then I would have lost $6. On the other hand if I sold the put instead and the stock goes down to $34 I would have to buy it at $35 losing $1, but remember that I made $3 on the put this means I would still be up $2, while at the same time getting into the stock at a discount.
One great thing about this strategy is that it can work very good with other investment strategies such as covered call writing, as long as the stock is something that will likely go up in the long term.
