Selling Puts

People will often want to buy a stock, but think the current price is too high. And so what they'll do is setup an automatic alert through their broker to let them know if or when the price drops to a level they're happier with. Alternatively they might actually place a "limit order" at the lower price they like so that when it drops they automatically buy.

Wouldn't you prefer that if the stock dropped in price you bought it at the cheaper price and had someone pay you some cash while you wait? Of course you'd prefer that.

Have cake, will eat it too

AAPL is currently at $488, and it's been on the up for a while now. Let's say you were interested in buying some shares, but you'd wait for them to pull back ~5% first. So down to roughly $465. You could put a limit order in for 100 shares at a price of $465, or you could sell a put option with a $465 strike price.

AAPL put options expiring on 4 October 2013 at a $465 strike are currently asking for $7.55 option premium. That means if you sold 1 put option contract, you'd receive $755 in income immediately (1 option contract x 100 shares x $7.55 premium). If between now and the 4th of October the price of AAPL dropped below $465 the option would be exercised and you'd have to purchase 100 shares of AAPL.

Which is exactly what would have happened if you had that limit order in place.

What kind of madness is this? Why would anybody pay you to do that?

This trade is just the opposite side of why people buy puts. As you're selling your taking on an obligation to buy stock at a predetermined price, and you have to buy it at that price. That carries with it similar risks to placing the limit order, and at least one more.

Let us assume for a moment AAPL unexpectedly announce some terrible news overnight, and the gaps down 15% when it opens the next morning. You're going to exercised and have to buy at $465 meanwhile the stock is trading at $414. You're immediately setting on a loss. If you'd placed a limit order what would have likely happened is you'd have been filled at the market price on open and been closer to $414. That's hardly guaranteed though, it could have just as easily opened how and then crashed down through the prices in the intervening minutes. In which case the outcome would be the same, the option at least gave you some cash upfront.

So be mindful, and make sure that your are really happy buying the stock at the strike price you chose. Your theoretical maximum loss in this trade is the strike price you chose, because if the value of the stock drops to zero you still have to buy it at that strike price.