In the last of a 4-part series, Kim Parlee speaks with Bryan Rogers, Client Education Instructor with TD Direct Investing, about the benefits and risks of selling a naked put. TD Direct Investing is holding an Options Month in June. Register at www.td.com/OptionsEducationMonth.
Bryan Rogers [00:00:19] Yeah. This week we're going to talk about selling Put's for income, Kim. But I do want to say I am sad that this is our last week to talk about options.
Kim Parlee [00:00:28] We'll have you back.
Bryan Rogers [00:00:29] All right. All right. So in week two, if anybody did remember back to week two, we did talk about buying a put option. And that's where you’re bearish on the market. You're hoping the stock will go down. If you're speculating, sometimes you can use it to protect an existing position and it's like insurance. So selling the put for income is like being the insurance company. You're collecting that fee, or that premium, for the obligation to deliver on something. In this case, the obligation to buy the stock if it is dropped down significantly. So in most cases, selling to open a put is uncovered or naked. Those fun terms we like to see with options. And it's going to be an unlimited, potentially, not unlimited, but a significant amount of risk. Because of the potentially significant risk, selling put options is only available in your margin account.
Kim Parlee [00:01:23] OK, there's a lot there. And again, we'll highlight again, this is the riskiest of the strategies we've talked about so far in terms of what you could do. So let's just go through some of the mechanics. How does the sale of a put for income work?
Bryan Rogers [00:01:37] Yeah, the seller of a put is going to collect the fee for the obligation to buy the stock at a set price. So all of this takes place within your expiration time frame. Remember, there's always an expiry date for every option. So the put seller is bullish. Remember, if you're buying a put, the put strategy is normally bearish, but when you're selling, you're kind of playing devil's advocate in a way and saying, hey, I don't think this stock is going to go down. I think it's going to stay above my strike price and I'm OK with betting on that and collecting that income. OK, so it's commonly used too, Kim, in some situations where if you're already considering buying that stock, you might consider selling a put to use as a point of entry. So you're going to get paid or collecting income to be able to enter into that stock at a lower price.
Kim Parlee [00:02:27] Interesting.
Bryan Rogers [00:02:27] Yeah. Once the put is sold, the seller gets to keep the income, but you might be forced to buy the stock at a lower price.
Kim Parlee [00:02:36] You alluded to earlier that the significant risk that could be associated with with selling a naked put and you talk about why you would want to do it. What if it goes wrong?
Bryan Rogers [00:02:48] Yeah, so the significant risk exists in a few ways. One is the lack of control that exists. So when we talked about covered calls in our last meeting, we didn't get into that as much because you're covered in that case. So any sell of an option, you don't have the ability to exercise or the right, they would say, to take action. When you're selling an option, you have the obligation. So it could happen at any time during the actual expiration period of the option. So the put seller could be forced to buy the stock at a higher price. The stock's dropped below the strike price at any time. And the second risk is not having the amount of cash or margin buying power available to do that. So the stock dropped significantly and you had to all of a sudden by it, you may be forced to sell it really quickly at that lower price and buy it at a higher price.
Kim Parlee [00:03:40] I think this is a good one to really go through an example in terms of what happens when it goes right and when it doesn't. So let's talk about some numbers. And I know you're going to take a look at IBM stock.
Bryan Rogers [00:03:52] Yeah, if you were, say, longer term, bullish on IBM stock and let's say it's trading at around $145 a share, you might already even have the cash to buy that stock. But maybe you're not quite ready and thinking, I think there could be a bit of a dip and you go and look at an auction chain and see that a $135 put I could sell for about $5 as an example in this particular example. And that would mean you're collecting $500, remember there is that 100 share multiple, collecting $500 for the obligation to buy IBM at $135 if it does drop below that. So you can technically rinse and repeat and do that again after the auction is expired and you get to keep that income.
Kim Parlee [00:04:38] Let's go through the other side, though, because that is what you want to have happen. What do we not want to have happen?
Bryan Rogers [00:04:44] So the best case scenario is that IBM stays where it's at. Remember, in this situation, we're not owning the stock. We haven't bought it yet. So the nice thing is we're collecting that $500 and we didn't have to put up the money for the stock at this point. There is some margin calculations and you should have the cash set aside. But the best case is that you're going to collect that $500, IBM stays above $135 a share. The worst case scenario is that if it does drop below $135, then you're going to be forced to buy IBM at a higher price. And the ultimate worst case would be if it dropped down to 0. So, to give you a quick example, if IBM dropped to $50, then I'd be forced to buy IBM at $135 a share. And technically, about $130 would be our cost because we collected that income, that $5 income. But now I own a stock and I paid $130 approximately for, it's only worth $50 a share in the open market.
Kim Parlee [00:05:42] That's not a great scenario, and again, in volatile markets, which we have seen in the past over the past year, that's where you something like that really comes to fruition. So, again, we're getting volatility both ways though. So it's been quite the time. Listen Bryan, thanks so much. I know that's all the time we have for today. And it's been such a pleasure having you talk about options, educating us about the risks and the opportunities with it. But again, before I let you go, tell us what else is happening with June Options Month with TD Direct Investing.
Bryan Rogers [00:06:15] Yes, the month is underway and it's completely focused on education related to options. We have live master classes that are interactive and webinars with special guests, and it's going to be at all kinds of different knowledge levels. You can actually learn other strategies about earning income. So this is something that excited you on today's session. Then check out www.td.com/OptionsEducationMonth and you can definitely register.
Kim Parlee [00:06:41] All right, Bryan, we'll talk again soon. You take care.
Bryan Rogers [00:06:45] Thanks Kim.