Are the recent swings in the stock market making you nervous? It’s common for the stock market to drop periodically. The past few years have seen prices almost steadily increase, so for some investors, getting back to a “normal” market has been a shock to the system. Fortunately there are ways to make some money while the direction of the market isn’t clear.
Options are a relatively easy way for individual investors to profit from a volatile stock market. They can provide some loss limits on a stock if the price declines.
Another method some investors use to bet on the stock price falling is “short selling”. It can be riskier than trading options on the stock, though.
Short-Selling
Selling a stock short provides a profit when the stock’s price falls. However, the risk is very high. The investor borrows the shares of the stock they think will decline and sells them in the market. If the stock’s price drops, the investor makes money. If it goes up, the investor loses.
Let’s say AllThingsSockMonkeys (ATSM) stock is trading at $100/share. (Note: not a real company.) You borrow the shares from a broker and sell them to the market. If the stock drops to $90/share, you net $10 for each share you sold. The lower the price drops, the higher your profit.
On the other hand, what if you’re wrong and the price rises to $110? Now you’re in the red $10/share. And in theory this loss isn’t limited, because the price could soar. The higher the stock price, the more money you lose.
By trading options instead of the stock, you can limit your losses. However, as you know, there is no free lunch in investing! So you limit your upside potential as well.
What are options?
Equity options allow investors to participate in the stock market while not actually buying (or selling) the stocks outright. You can trade options on a stock according to whether you think the stock’s price will rise or fall, or even stay mostly the same.
Using options allows you to hold off on a big capital investment, since you don’t buy (or borrow) the underlying stock at first. But at the same time, by using options correctly, you can still pocket some money from the trade.
You can sell or buy options, just like the stocks themselves. You can also do both at the same time, which known as a spread. Depending on which direction you expect the stock price to go, or whether you want to protect against a price decline, you might choose a different option to use.
When buying an option, you pay a premium to the seller. However, when you sell an option, the buyer pays you the premium. So selling options can be a good way to generate some income, whatever the behavior of the underlying stock.
Put option
This equity option means you’re “putting” away the underlying stock to someone else when you buy a put. It gives you the right to sell a stock at a predetermined price (“strike price”) and date. This is an excellent choice for investors who believe the stock price will drop. It’s much less risky than a short sale because your loss is limited by the strike price.
Conversely, if you sell a put, you collect the option premium. You have the obligation to buy the stock if the other side exercises the put they bought. This works well if you like the stock whose put you’re selling, and you expect the price to either rise or stay the same.
This strategy can provide you with income in a volatile market, where you’re not sure which way the stock is going. Or if it seems to be going in all directions at once!
Let’s say AllThingsSockMonkeys stock is still trading at $100/share. You sell one 90 January put option on ATSM for $5 premium, and it expires in February. In this example, the strike price is $90. The put option covers 100 shares of stock, so you’ve just netted $500 ($5*100) over time, less fees.
(These numbers are all completely made up too, by the way.)
In February, if ATSM is at $90/share, you’ll have to buy the 100 shares. But you’ll have kept the $5/share premium. That lowers the net cost to $85 per share of ATSM. This is why you want to sell puts on stocks you want to own at the strike price you choose. This trade benefits you when the stock price does go down, because you buy the stock you like at a cheaper price point.
If ATSM is higher than $90, and in this example stays the same (at the original price of $100), the put will expire worthless. You still keep the premium money you received, and you have no obligation regarding the stock.
Either way, whether the stock goes up or down, you win. You either buy the stock you like at the price you want, offset by the premium you received for the put. Or, you simply keep the premium.
Put Spread
Another way to generate income in a volatile market is to enter into a “bull” put spread. It’s also known as a credit spread, because you make money at the start of the trade. The downside is limited, though of course so is the upside.
With a bull put spread, you sell a put (short) with a higher strike price, and simultaneously buy a put with a lower strike. This is best on a stock that’s likely to rise mildly in price. Selling the put at a higher strike provides income, while buying the lower strike put protects against a decline in the stock.
The maximum profit using this strategy is the net credit. This is the difference between what you received for writing (selling) the put, and the amount used to purchase the put with the lower strike.
If the stock price ends up higher than the higher strike, the option expires worthless, and you keep the net premium you received. This is the best case scenario.
The break-even point occurs when the stock price lands lower than the higher strike (short) put, by an amount equal to the net credit received. But the price is still higher than the lower strike put, which expires worthless, so you don’t have to buy anything.
In the worst case, the price drops below the lower strike price. Here the investor has to buy the stock at the higher strike price and sell it at the lower price. Therefore, the maximum loss is the difference between the strike prices, less the net credit received.
Suppose AllThingsSockMonkeys is still trading at $100/share. Investors think it will rise a bit in a month. So you buy one 90 February put for $100 and sell one 95 put for $300 (all imaginary, of course). The net credit is $200, which is the most in profit you can get.
If ATSM remains at $100 or goes higher, both puts expire worthless and you keep the $200.
The breakeven for this spread is at $93, which is the higher strike of $95 less the net credit of $2 (remember 1 option = 100 shares). If the price is above $93, you’ll have made money on the trade. If it’s below, you’ll have lost money.
What if the price declines to $85? In this case you buy the stock at $95 and sell it at $90. You’re out $500 (difference in strike price*100 shares). But, you received $200 from entering into the trade, so your net loss is $300.
This is the maximum loss, no matter how the stock performs. The long put (the one you bought) limits the sale price to $90. If you hadn’t bought it, when the price dropped to $85 then you would have to sell at $85 instead. The long “leg” of the trade protects you against steep price declines.
Summary
There’s no reason not to make some money on increasing stock volatility, if you can. Writing puts allows you to keep the premium you collect. Or, buy a stock you like at a price you like, in addition to keeping the premium.
A put spread protects against a stock drop, but allows you to profit from a stock price rise as well. Both profit and loss on this trade are limited. You don’t want to use it on a stock that you expect will rise significantly in price, because in that case you wouldn’t want to limit your gains.
Your choice of strike price(s) will determine how much income you’ll receive. In the case of the spread, the net income is also your maximum profit. Choose wisely, remembering that you might have to pay money out if the stock drops below your lower strike put.
Which option you choose is up to you. Bear in mind that all these strategies normally come with some kind of fee or commission from the place you’re buying the options from. Make sure you’re not paying more in commissions than you can generate in income!
Now let’s hear your put selling ideas in the comments below. If we use yours as a SteadyDime recommendation we will give you one free month to our put selling program. A $119 value!