When investors think about options trading, they often imagine high-risk, fast-moving trades. However, one options strategy—selling put options—offers a more conservative way to earn income while potentially buying stocks you want at a discount. In this article, we’ll take a deep dive into how selling put options works, explore an example using Microsoft (MSFT), and discuss why this strategy might be appealing to long-term investors.
What Does it Mean to Sell a Put Option?
Selling a put option gives the buyer the right, but not the obligation, to sell you shares of a stock at a predetermined price (called the strike price) by a certain expiration date. In return for taking on this obligation, you collect a premium—the income from selling the option. This strategy is especially useful if you’re willing to own the stock and would prefer to buy it at a lower price than its current market value. Even if the stock never reaches your target price, you still get to keep the premium.
The Core Concept: Earning Income While Waiting to Buy a Stock
The appeal of selling put options is that you can generate passive income from the premiums, while potentially purchasing the stock at a discount if its price falls. If you don’t end up buying the stock, you simply keep the premium and can repeat the process. Essentially, it’s a win-win strategy if managed carefully. Now, let’s walk through a real-world example with Microsoft.
Example: Selling Puts on Microsoft (MSFT)
Imagine you’re interested in buying shares of Microsoft (MSFT), which is currently trading at $320 per share. You think the stock is a solid long-term investment but would prefer to buy it at $300 per share, which is a bit lower than its current price. By selling a put option, you can potentially buy Microsoft at this lower price, and even if the stock doesn’t dip that low, you’ll earn income from the premium you collect.
Step 1: Choose a Strike Price Below the Current Market Price
You decide that you’re comfortable buying Microsoft at $300 per share, which is below the current market price of $320. So, you sell a put option with a strike price of $300, set to expire in one month.
- Strike Price: $300
- Expiration Date: 1 month
- Premium Collected: Let’s say you collect a premium of $4 per share for selling this put option.
Since each options contract represents 100 shares, you would collect a total premium of $400 ($4 per share x 100 shares) just for agreeing to potentially buy Microsoft at $300.
Step 2: Possible Outcomes
When you sell a put option, there are two possible outcomes by the time the option expires: either the stock stays above the strike price or it falls below.
Outcome 1: Microsoft’s Stock Price Stays Above $300
If Microsoft’s stock price stays above $300 by the expiration date, the put option expires worthless, meaning you won’t have to buy the stock. The buyer of the put option will not exercise their right to sell you the stock since it’s still trading above $300 in the open market. This is the ideal scenario for income generation because:
- You keep the $400 premium you collected when you sold the put option.
- You don’t have to buy the stock.
- You can then repeat the process by selling another put option if you still want to try buying the stock at a lower price.
In this scenario, you’ve earned $400 for simply agreeing to buy Microsoft at a price you felt comfortable with—something that never happened!
Outcome 2: Microsoft’s Stock Price Falls Below $300
If Microsoft’s stock price drops below $300 by the expiration date, the buyer of the put option will exercise their right to sell you the stock at $300 per share. As the seller of the put, you are obligated to buy the stock at this price. However, there are still some positives:
- You still keep the $400 premium, which effectively lowers the cost of purchasing the stock.
- Your total cost for the stock is reduced to $296 per share ($300 strike price – $4 premium), which is even better than your initial target price.
- You’ll end up owning 100 shares of Microsoft, costing you $30,000 in total, but with the premium factored in, your effective investment is $29,600.
In this outcome, you’ve still achieved your goal of owning Microsoft at a discounted price, even though the stock price dropped.
Additional Examples
Let’s explore additional examples of selling put options on different stocks to give you a broader perspective on how this strategy works across various companies. Here are three more scenarios with real-world stocks that will help you see the potential flexibility and profitability of this approach.
Example 1: Selling Puts on Apple (AAPL)
Apple (AAPL) is one of the most popular and stable stocks in the market, making it a good candidate for selling put options, especially if you’re a long-term investor looking to buy it at a discount.
- Current Price: $180 per share
- Desired Buy Price: $170 per share
You believe Apple is a great stock but would prefer to buy it at a lower price of $170. To achieve this, you sell a put option with a strike price of $170, set to expire in one month.
- Strike Price: $170
- Expiration Date: 1 month
- Premium Collected: Let’s assume you can collect $2 per share for selling this put.
Since each option contract represents 100 shares, you’ll collect a $200 premium ($2 x 100 shares) just for agreeing to potentially buy Apple at $170 per share.
Possible Outcomes
- AAPL stays above $170: The put option expires worthless, and you keep the $200 premium without having to buy any stock. You can repeat this process in the future to earn more income.
- AAPL falls below $170: You are obligated to buy Apple at $170 per share. But because you already collected $200, your effective purchase price becomes $168 per share. This allows you to buy Apple at a price lower than the current market value.
This strategy is ideal for investors who are bullish on Apple but prefer to buy shares at a slightly lower price.
Example 2: Selling Puts on Tesla (TSLA)
Tesla (TSLA) is a more volatile stock, making it a good candidate for selling puts if you’re comfortable with potential price swings and are bullish on Tesla’s long-term prospects.
- Current Price: $850 per share
- Desired Buy Price: $800 per share
Let’s say you’re comfortable owning Tesla but only if the price drops to $800. You can sell a put option with a strike price of $800, expiring in one month, and collect a nice premium for taking on the risk of buying the stock.
- Strike Price: $800
- Expiration Date: 1 month
- Premium Collected: Let’s assume you collect $12 per share for selling this put.
Since each contract represents 100 shares, you’ll collect a total premium of $1,200 ($12 x 100 shares).
Possible Outcomes
- TSLA stays above $800: The put option expires worthless, and you keep the $1,200 premium without buying any shares. You can repeat the process next month if you still want to acquire Tesla at a lower price.
- TSLA falls below $800: You are obligated to buy 100 shares of Tesla at $800, for a total cost of $80,000. However, your effective purchase price is reduced to $788 per share after factoring in the premium you collected, giving you a discount.
This example is great for investors who believe in Tesla’s long-term growth but prefer to buy shares at a more favorable entry point.
Example 3: Selling Puts on Coca-Cola (KO)
Coca-Cola (KO) is a classic blue-chip stock, known for stability and consistent dividends. If you’re a conservative investor looking to own a solid, dividend-paying stock at a lower price, selling puts on Coca-Cola might be appealing.
- Current Price: $60 per share
- Desired Buy Price: $55 per share
You’re interested in buying Coca-Cola if it drops to $55. To set up this trade, you sell a put option with a strike price of $55, expiring in one month.
- Strike Price: $55
- Expiration Date: 1 month
- Premium Collected: You might collect $1 per share for selling this put.
Since each contract covers 100 shares, you’ll collect a total premium of $100 ($1 x 100 shares) for agreeing to buy Coca-Cola at $55.
Possible Outcomes
- KO stays above $55: The put option expires worthless, and you keep the $100 premium. You can sell another put option in the future to collect more income.
- KO falls below $55: You are obligated to buy 100 shares of Coca-Cola at $55, for a total cost of $5,500. After factoring in the premium you collected, your effective purchase price becomes $54 per share, providing you a discount.
This is a low-risk example suitable for conservative investors looking to enter a position in a stable, dividend-paying company like Coca-Cola.
Why Use These Strategies?
Selling put options can be an effective tool for:
- Earning Passive Income: Whether or not the stock price falls, you get to collect the premium each time you sell a put. It’s a way to generate consistent income, especially in stable or slightly volatile markets.
- Buying Stocks at a Discount: If the stock does fall to your desired strike price, you end up buying it at a discount compared to the current market price. The premium you collect further reduces your cost basis.
- Reducing Portfolio Volatility: If you target high-quality stocks with lower volatility (like Coca-Cola or Apple), selling puts can be a relatively conservative way to earn income while building your portfolio.
- Flexibility: You can adjust the strategy depending on market conditions. For more volatile stocks like Tesla, higher premiums make the risk worthwhile. For stable stocks like Coca-Cola, you can use this strategy to slowly accumulate shares while earning steady income.
Risks to Consider
While selling put options can be a conservative strategy, it’s important to understand the risks:
- Stock Price Drop: If the stock price drops significantly below the strike price, you will still be obligated to buy it at the strike price, even if it’s now worth much less. This is why it’s crucial to only sell puts on stocks you genuinely want to own.
- Capital Commitment: You need to have enough cash set aside to buy 100 shares of the stock at the strike price, should the option be exercised. This is known as a cash-secured put strategy, and it ensures you’re ready to buy the stock if necessary.
- Limited Upside: If the stock price rises significantly, you won’t participate in any of the upside gains. Your profit is limited to the premium you collected, which can be frustrating if you miss out on large stock price rallies.
Final Thoughts
Selling put options is a versatile strategy that offers investors a way to generate income while positioning themselves to buy stocks at a discounted price. Whether you’re targeting high-growth, volatile stocks like Tesla, or more stable dividend-paying stocks like Coca-Cola, this strategy provides a flexible and potentially profitable approach to stock market investing.
With careful risk management, selling puts can help you enter positions on stocks you believe in long-term, all while getting paid for your willingness to buy at a lower price. It’s an ideal strategy for those looking to build their portfolios in a disciplined and strategic manner.