Writing puts can be a great source of income. It can also be a great way to purchase stock at a significant discount. And the best news is that writing puts is a relatively simple process.

How Does It Work?

The official definition of a put option is a contract that gives the holder the right, but not the obligation, to sell 100 shares of a certain stock at a certain price by a certain date.

But a simpler way to think about puts is to consider them basically to be insurance policies. For example, if I own 100 shares of the XYZ Company which trades at $33/share, I can purchase a put option that gives me the right to sell my stock for $30/share anytime up to and before the expiration date of the option. Like all insurance policies, I have to pay a premium, and purchasing a put option is no different.

And why would I want to sell my stock for $30/share when it’s trading at $33/share? I wouldn’t, of course, but what happens if the share price really tanks? If the stock drops down to $20/share, my put option would give me the ability to sell the stock for $30/share. Sure, I’d be out $3 per share plus the amount I paid for the put, but I wouldn’t be down the full $13 per share that I would’ve had I not purchased the put in the first place.

In short, by buying a put I, in effect, have insured my stock at $30/share.

Become an Insurance Company

Writing puts simply places you on the other side of the trade so that you become the insurance company. When you write, or sell, a put you receive a cash premium in exchange for giving someone else the right (but not the obligation) to sell you their stock at a certain price by a certain date. If the stock stays above that price (called the strike price) you keep the premium and the put expires worthless. Ah, a successful insurance venture.

Of course, the stock might fall below the strike price, so it’s always important that you only write puts on stocks that you’re willing to own at the strike price selected. And it’s also important that you have the necessary funds to purchase the stock in case you’re assigned (i.e. the put holder exercises the option).

The Case for Writing Puts

If done properly and intelligently, writing puts has two distinct benefits:

1. Income Generation – As long as the stock remains above the strike price, you can generate a steady stream of income. You can treat the income like a special dividend and spend it, or you can accumulate it and grow your cash reserves so that you’re able to write even more puts in the future.

2. Acquiring Discounted Stock – Say a stock you like is trading at $42/share and you think it’s already attractively priced and you would be willing to own it yourself if it came down some in price. Let’s suppose you wrote a put on it with a $40 strike price and an expiration date one month away for a $2 premium (or $200 in cash since you each contract represents 100 shares of the underlying stock). Think about what you’re actually doing–you’re getting paid $200 to offer to buy a stock for $2/share less than what it’s currently trading at. And if you do get assigned? Factoring in the premium you receive, you don’t actually pay $40/share, you pay $38/share.

Conclusion:

Writing puts, like any kind of option trading, is not for everybody. And it’s not without risk either. But it may be worth your while to conduct further research to determine if the strategy has a place in your portfolio.