Welcome to the third installment of my three-part series to explore new opportunities to generate more passive incomes with options. The first post covered the basic of options concepts and the second post covered how to sell covered call options to increase your passive income. In this post, I’ll be exploring and providing more in-depth coverage on how to increase your passive income by selling naked put options.
Why Am I Selling Naked Put Options
When trading put options, my philosophy is very similar to trading call options. I believe that if you are trading options, you are participating in a form of gambling. I consider the investors that purchase my put options the gamblers because they are betting on the direction of the stocks. On the contrary, the investors that sell the options are the houses because they get to set the terms and conditions that can work to their advantage.
I think that I can use a few simple strategies that will allow me to legally tilt the odds in my favour by selling naked put options. I have three main purposes when it comes to selling naked put options. The first purpose is to earn extra passive incomes without having to make any additional capital investments. The second is to purchase stocks that I want to own at a cheaper price. Last, but not least, to balance out the covered call options that I sold.
When the stock market goes up, I will make money from my stock portfolio and all the naked put options that I sold. On the other hand, when the market goes down, I’ll make money from my covered call options. If the stock market goes sideways, I will most likely make money from both types of options. As a result, there are always opportunities for me to make money regardless of the market condition.
What Factors To Consider When Selling Naked Put Options?
The first factor to consider is the time value of the options contract. The longer the time to expiration, the more premium the purchaser needs to pay. Also, as time goes by, the value of the option decays, which means time is working for you (the seller) instead of against you (the purchaser). Hence, I use this factor towards my advantage by selling options contracts that are between six and fifteen months in duration.
One of the reasons that I set this contract duration is to maximize the premium that I collect. Another reason is to provide the flexibility to make adjustments when there is market news that affects the stock. Third, I want to minimize the number of contracts that I write to lower my trading costs.
The second factor to consider is the current price of the stock. I rarely sell any of my naked put options when the stock price is increasing or near its 52 weeks high. I usually sell my naked put options when the stock is near its 52 weeks low. By choosing a lower price point to sell my naked put options I have built in some downside protection for myself.
The third factor to consider is volatility. It can either be the volatility of the underlying stock or the stock market itself. Either one will provide you with an increased premium.
When Is A Good Time For Selling Naked Put Options?
To increase my chances of investment success (make more money), I timed the market when selling naked put options. I usually pick a time when the stock is trading near or at 52 weeks low or there’s bad news (“blood on the street”) related to the company. This way, I already have a little cushion to work with and will be buying the stock even cheaper if my options get exercised.
What Is Best The Strategy For Setting The Strike Price?
I rarely set the strike price of my naked put options at 5% less than the current market price unless I really want to buy the stock. For any of my naked put options contracts, if they get exercised, my adjusted cost base for the underlying stock has to be at least 12% lower than the current market price. This means that the strike price is often set at 8% or lower than the current market price. The premium received will normally be 2% or higher.
What Stock To Choose To Sell Naked Put Options?
I don’t sell any naked put options for stocks that I am not willing to own for the long-term. I only select companies with brand name recognition and have a great earning history/potential. Currently, some of the stocks that I sold naked put contracts for are Google Inc., Visa Inc., and Johnson & Johnson.
Selling Naked Put Options Just To Earn The Premium
When selling naked put options, I have no issues buying the underlying stock if the market price falls below the strike price. I know that I will at least get a decent discount when buying the underlying stock. However, sometimes, I just want to earn the premium. If this is the case, I set the strike price a lot lower than the market price.
For example, in late 2017 when the market price of Visa Inc. was around $110/share, I sold five contracts expiring in January 2019 with a strike price of $70/share. I collected roughly $1.22/share or $610 in premium. To reach $70/share, Visa Inc. would have to drop more than 36% from $110/share. The chances of such a great company’s stock price dropping by that much within 15 months are very minute. As of this writing, Visa Inc.’s stock price is at $142/share.
Selling Naked Put Options To Buy A Stock Cheaper
From time to time, there may be a stock that I want to buy. However, I don’t want to buy at the current market price, I want to buy it cheaper. To do this, I sell a naked put options with a strike price that’s at or just slightly below the current market price.
For example, during the summer of 2017, Chipotle Mexican Grill (CMG) had another food poisoning scare and their stock plummeted 10% in one day. When I smelled blood, I started to move in and take action to buy that stock. Since I already owned 100 shares of CMG, I was in no hurry to buy it right away. So I sold one naked put options with the strike price close to the market price of $360/share, expiring on January 2018 and collected $24.89/share or $2,489 in premium.
In January 2018, the price of CMG dropped to about $337/share, which was lowered than the strike price of $360/share, so I had to buy 100 shares of CMG at the strike price. At the time, I pretty much broke even as my adjusted cost base to buy CMG was about $336/share (= strike price – premium = $360/share – $24.89/share). As of this writing, the market price of CMG is now trading at $518/share, providing me with a handsome paper profit $184/share.
| Options – Contracts | Ticker | Expiry Date | Strike Price | Market Price | Premium | Status |
|---|---|---|---|---|---|---|
| Naked Put – 4 | BCE | January 18, 2019 | $56.00 | $53.62 | $780.00 | Active |
| Naked Put – 5 | BNS | January 18, 2019 | $70.00 | $77.92 | $990.00 | Active |
| Naked Put – 3 | CNR | January 18, 2019 | $90.00 | $115.00 | $990.00 | Active |
| Naked Put – 6 | DOL | January 18, 2019 | $46.67 | $48.26 | $1,078.00 | Active |
| Naked Put – 5 | FTS | January 18, 2019 | $42.00 | $42.52 | $790.00 | Active |
| Total Premium: | $4,628.00 | |||||
Table #1: Canadian Covered Call Options contracts sold in 2018.
Passive Income Generated By Selling Naked Put Options
Table #1 lists the naked options that I had sold from my Canadian stocks portfolio. Currently, 4 out of 5 naked put options (BNS, CNR, FTS, and DOL) are out of the money, meaning the market price is higher than the strike price. Only one options (BCE) is in the money, meaning the market price is lower than the strike price. For BCE, I will most likely have to buy the stock if the stock price doesn’t increase over $56/share.
| Options – Contracts | Ticker | Expiry Date | Strike Price | Market Price | Premium | Status |
|---|---|---|---|---|---|---|
| Naked Put – 1 | GOOG | January 18, 2019 | $600.00 | $1,205.38 | $789.00 | Active |
| Naked Put – 1 | GOOG | January 18, 2019 | $850.00 | $1,205.38 | $5,300.00 | Active |
| Naked Put – 2 | ITW | January 18, 2019 | $125.00 | $135.14 | $630.00 | Active |
| Naked Put – 3 | JNJ | January 18, 2019 | $115.00 | $135.11 | $963.00 | Active |
| Naked Put – 2 | SPY | January 18, 2019 | $260.00 | $285.79 | $770.00 | Active |
| Naked Put – 5 | V | January 18, 2019 | $70.00 | $142.10 | $610.00 | Active |
| Naked Put – 3 | V | January 18, 2019 | $90.00 | $142.10 | $1,155.00 | Active |
| Total Premium: | $10,217.00 | |||||
Table #2: U.S. Covered Call Options contracts sold in 2017/2018.
Table #2 lists the naked put options that I had sold from my U.S. stocks portfolio earning a total of $10,217 (USD) in premiums. Currently, all of the naked put options are out of the money. At this rate, I will be keeping all the $10,217 in premiums for free and won’t have to buy any of the stocks.
Did you notice that for Visa Inc. (V) and Alphabet Inc. (GOOG), I have sold options at two different strike prices? The options with higher strike prices indicated that I was more than willing to buy those stocks at that strike price. For the same options with the lowered strike prices, I sold those options just to earn a premium. I would definitely love to buy those stocks at the lower price, but I don’t think those two stocks will be dropping that significantly.
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Selling Naked Put Options For A Living
Since I already own a sizeable ($1.2M) stock portfolio and I am currently selling covered call options, selling naked put options for a living is the next logical step. I want to continue to generate more and more passive income in the future and selling naked put options is definitely part of my strategy once I achieved my financial independence goals.
The Risks Associated With Selling Naked Put Options
With any types of investments, there is always some sort of associated risks. And naked put options are no exceptions either. One of the risks of selling naked put options is that if the underlying stock dropped significantly or goes to zero, you’ll have to buy the stock at the strike price. The worse case scenario is you lose 100% (minus the premium) of your money.
To mitigate the risk of significant loss, there are a few measures that one can take to minimize one’s lost. The first measure is to choose stocks with a strong track record of increasing their dividends and earnings that can easily cover their dividend payments. These ways, even if the stock price experiences a significant fall, you’ll still get your dividend payment once you buy the stock.
The second measure is to sell the naked put options for brand name stocks only. By that, I mean chose the companies that are the dominant players in their industries or have great competitive advantages over their peers. These are the reasons why I chose Google Inc., Visa Inc., and Johnson & Johnson.
Limitations Of Naked Put Options
One of the limitations of naked put options is the cap on your gains on the options- the premium. Sometimes, you are probably better off if you bought the stock instead of selling a naked put options. For the two options that I sold for Visa Inc. and Alphabet Inc., I would make a lot more money if I just bought the stock at the time that I sold my naked put options.
My Two Cents
To earn more passive income, you may not have to invest more money or take additional risks. If you have a great portfolio of stocks, you can increase your passive income and investment returns by selling naked put options. With any types of investments, it’s best that one does the required research to understand what one is investing in. Only invest in what one fully understands and not taking more risks than one can accept.
So readers, do you own currently own a portfolio of individual stocks? If you do own individual stocks, would you consider selling naked put options to increase your passive income and returns? If you want to own a stock, would you sell a naked put options or would you just buy the stocks?