By selling a put option you are selling someone the right to sell shares of a company at a predetermined price. Now no one is going to give up their "option" for free so in return the seller receives an option premium. We'll use Coca-Cola (KO) (Full Analysis Here) since shares are currently trading for about a 1.50% premium to my fair value calculation of $40.75. If I'm a stickler for not paying more than what I deem to be a fair value price then Coca-Cola wouldn't be a possibility right now unless I use put options. Let's look at the options that expire September 26th.
This is the option table for Coca-Cola as of around 1:15 PM yesterday.
Strike or Strike Price - The price that determines whether an option can be executed or expire worthless. In the case of put options if shares are trading below the strike price the option can be executed. If shares are trading above the strike then the option expires.
Bid - The amount that buyers are offering for that option.
Ask - The amount that sellers are asking for that option.
Expiration or Expiration Date - The date at which the option expires.
Write an option - The seller of the option.
Buy an option - The buyer of the option.
In the money - Option would be executed if the expiration was today. In the case of put options the current share price is lower than the strike price.
Out of the money - Option would expire worthless if the expiration was today. In the case of put options the current share price is higher than the strike price.
Each option contract represents 100 shares.
Like most things there's more than one way to skin a cat so to speak. I'll run through the calculations for one of the options and then give a summary of all of the options at the end. Let's look at the $40.50 strike price since that is the closest to my fair value price of $40.75. I'll assume commission costs from my brokerage firm of $7.95 + $0.75 ($8.75) per contract and we'll sell just 1 contract representing 100 shares. All calculations will be based off the prices from above with a sell date of August 25th and an expiration date of September 26th and assume that you are selling to open the put option.
When you sell the option you receive an option premium upfront and can use that capital right away. In the above case of the $40.50 strike price the bid is $0.25 and the ask is $0.32. We'll assume that you sell to open the put option at $0.29 which is about halfway between the bid and ask. The option premium that you would see deposited in your bank account would be $0.29 * 1 contract * 100 shares per contract - $8.75 commission = $20.25. Since standard stock option contracts in the United States can be executed anytime they are in the money, your brokerage will require you to have enough cash in your account to cover the option if it's executed. In this case the cash requirement would be $40.50 strike * 1 contract * 100 shares per contract - $20.25 option premium = $4,050.00. If the share price is trading higher than the strike price of $40.50 (i.e. out of the money) then you would get to keep the full option premium as profit. Your percentage return would be $20.25 / $4,050.00 = 0.50% which is equivalent to an annualized return of 5.73%.
I also like to calculate what my cost basis would be if the option is executed. That way I know what price I'm effectively paying for the shares. In the case of the $40.50 strike put the per share cost basis would be calculated at follows $40.50 strike * 1 contract * 100 shares per contract - $20.25 option premium + $7.95 standard commission = $40.38. My brokerage charges the base purchase commission of $7.95 if the option is executed.
The following is the information I like to look at for each option combination.
You'll notice that the option premium declines the further out of the money the strike price is. That makes sense because it would require a nearly 5% decline for the $39.50 strike put to be exercised. For a company as stable as Coca-Cola those kinds of price swings aren't all that common over any given one month period. As the strike price gets closer to the current price the option premium increases. At strike prices above the current price the option premiums offer great returns but will most likely end up being executed.
You have to balance your desire for a solid return if the option expires worthless with the cost basis if the option is executed. It's important to balance the risk/reward, well the way I look at it the reward/reward. My strategy when selling put options is to try to find combinations that give a 10%+ annualized return if the option expires worthless (out of the money) and a cost basis I'd be happy to buy shares at on the open market if the option is executed (in the money).
If you are comfortable paying fair value for a solid company like Coca-Cola then the $41 strike put could be intriguing. It offers a solid 10.46% annualized return if it expires and a $40.71 cost basis if it's executed. That's a pretty good trade-off between the two outcomes. The one big factor against selling puts is that it puts a hold on a large chunk of capital. With the $41 strike put you would need $4,100.00 set aside
Selling put options can be a great way to both generate extra income from your capital or to purchase shares at lower prices than are currently offered in the market. You can even use margin to reduce the capital outlay but that introduces a whole set of risks and issues. If you have capital lying around waiting to be invested and specific companies in your target for purchase then selling put options can offer the best of both world.
Here is a link to a calculator so you can make your own calculations and see different scenarios.