Get Rich with Dividends: A Proven System for Earning Double-Digit Returns

Selling Puts

Some investors are big fans of selling naked puts. Unlike an out-of-the-money covered call in which you already own the security and you can’t lose any money, selling a naked put involves risk. It’s called naked because it’s not tied to a stock. If you were short the stock and sold the put, it would not be naked.

When you sell a put, the buyer has the right to sell you the stock at the strike price before or at expiration. Therefore, when you sell a put, you need to be prepared to buy the stock.

Put sellers typically sell out-of-the-money puts—a strike price below the current market price.

In return, you receive the cash that the buyer pays for the put. If the stock does not reach the put’s strike price, you keep the cash. If the put does wind up in the money, you may be forced to buy the stock, which can get expensive.

Think of it this way, the put buyer is purchasing insurance on her stock. If the stock price goes down, she is protected by the puts. You, as the put seller, are the insurance company. You collect and keep the insurance premium and take on the risk if something goes wrong.

Let’s say Merck (NYSE: MRK) is trading at $43 and you sell five puts on Merck with a strike price of $40 for $1 per contract. Since option contracts represent 100 shares, you’ll receive $100 per contract, or $500. If the Merck puts are in the money (below $40) and you are required to buy the stock, you will need to pay $20,000 (500 shares × $40 per share).

Investors who sell naked ...