Income from options 2

Jun 11, 2010

There is another way you can earn income from the use of options. Earlier we talked about employing a covered call strategy to supplement your dividend income. You can earn money from selling a call, but you can also earn money from selling a put.

Recall that when you buy a put option you are making a contract to sell 100 shares at the strike price on or before a specific date in the future. Now consider the other side of this transaction.

Put-Selling: When you sell a put option you are agreeing to buy 100 shares at the strike price on or before a specific date in the future. Please keep in mind that you would only ever enter into this contract if you actually want the underlying shares. Don’t speculate or you may end up with something you do not want.

Ideally, the contract strike price is below the current price of the underlying shares. You are therefore agreeing to buy 100 shares of a company that you want at a price that you think is fair (or even below market value). You earn a premium for making this agreement.

The purchaser believes that the share price will fall even further and hopes to limit his or her loss. As the seller you believe that the drop in price is only temporary and that buying the company at this new lower price is a bargain.

However, it is entirely possible that the share price will not fall below the strike price before the expiration date, and you will never be ‘put’ the shares (forced to buy). In that case you will have earned a premium and never had to buy anything at all.

For example, Apple stock (aapl) currently trades for approximately $248 per share. You like Apple and think they are a strong company, but not at the current price. However, at $220/share Apple looks very attractive. You could sell the July $220 put for $3.60. Keep in mind that each contract controls 100 shares. Therefore, you would earn $360 from selling the put contract. And, if the price of Apple shares fell below $220 before the 3rd Friday in July (the expiration date) you would have to buy 100 Apple shares at $220 each.

If Apple never falls below $220 then you do not have to buy the shares, but you still get to keep the premium – in this case $360, which is a good thing. If Apple falls below $220 a share you get to buy them at a price that you thought was a bargain. This is also a good thing. Your only risk in this scenario is that Apple shares fall far below $216.40. Were that to occur you would be in a loss position, but you would own the shares and be able to take advantage of any later upswing in the stock.

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One Response so far | Have Your Say!

  1. ross
    June 24th, 2010 at 7:05 PM #

    Thanks for your comment John, glad you liked the article.

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