Selling Puts

According to Stansberry Research founder Porter Stansberry, most people will probably never get involved in options…

You have to do what you’re comfortable with… and do what you understand. “But know this,” he continues, “You can make 5% or more every few months, nearly risk-free, in the options markets. You do this by selling options, not buying them.”

Buying options can be incredibly risky. As Porter explains, “It’s a strategy that should be used mostly by professional investors to hedge against losses – insurance, essentially. Buying options is a cost of doing business for professional fund managers. Selling those options is an easy way for us to generate large amounts of safe income.”

How safe is selling options? To discuss this idea, we sat down with Dr. David Eifrig, who has been showing readers of his Retirement Trader advisory how to use options to generate safe income.

To learn more about this radical approach to generating income, read on…

Stansberry Research: Doc, you’ve told folks looking for a conservative, high-income, retirement-friendly trading strategy they can’t find a better tool than selling put options. Can you explain how this strategy works?

Dr. David Eifrig: Sure. Put options work the same way as homeowners insurance. When you insure your home, you are simply buying the right to sell your house to the insurance company if certain things happen, like a fire or a storm.

In return for that protection, you pay the insurance company a certain fee – known as the insurance premium – to accept those terms, whether or not you ever actually exercise the insurance policy. And most homes don’t burn down… Most homes don’t blow away in a storm.

With put options, instead of buying the protection, you’re acting like the insurance company.

You see, when you sell a put option, you’re agreeing to buy someone else’s stock at a certain price – known as the “strike” price – under certain conditions, for a limited period of time. In return, you’re getting paid a certain fee – the option premium – to accept those terms.

In the example of home insurance, a person would exercise the policy only after a catastrophic event… when something like a fire or severe weather damages the value of his or her home.

Again, a put option works the same way. In this case, the holder would exercise his right to sell the stock to you only if the market value of the stock falls below the strike price you agreed to pay.

If the stock goes up or even stays where it is – as long as it doesn’t fall below the strike price – you get to keep your premium. If it does drop below that price, you’re obligated to buy the stock, but the premium you received ensures you get a discount to the current price. It’s almost like being paid to buy a stock at a discount – or getting paid to offer $250,000 for a house the buyer is asking $300,000 for.

And the best part of the strategy is you don’t have to be right forever. You just need to be right for a few months, because your obligation to buy expires when the option expires.

Stansberry Research: Can you walk us through an example with a stock?

Eifrig: One of my favorite examples is Johnson & Johnson (NYSE: JNJ). It’s a big, strong company, it pays a growing dividend, and it stands to benefit from one of the biggest trends in the world: the increased medical spending of aging Baby Boomers.

In early 2011, the company announced some product recalls that caused the shares to sell off a bit. But the company had moved to correct the problems, so I thought the selling was overdone… And the company had just released a great earnings report. So shares were cheaper, but all the great points I mentioned earlier were still intact.

So we took advantage in Retirement Trader and sold puts on JNJ. Like all put-selling trades, there were two potential outcomes here. If the stock stayed at our strike price or moved higher, we would get to keep our premium and make a quick 8% gain in just three months. This works out to an annualized return of 30%-40%. On the other hand, if the stock fell below our strike price, we’d own the shares at a discount to the even cheaper price.

When you’re talking about a quality company like JNJ, that is a win-win proposition.

Stansberry Research: But what happens if the stock crashes, say because of an accounting scandal or a major product recall?

Eifrig: In that scenario, you would have to buy a stock for much more than it is currently trading for. It could happen because every investment carries risk, and no one can predict the future.

So, one key to selling puts safely is figuring out what the company’s stock is really worth and trading the best companies.

Just like an insurance company needs to know the details of your home – things like how much you paid for it, how big it is, the value of any valuables you have, and so on – you need to know the details of the companies you sell puts on to be sure they’re fundamentally sound.

An insurance company wouldn’t want to insure an old house with a faulty electrical system. Similarly, you don’t want to “insure” just any stock. You want to find quality stocks that you like and would want to own anyway. Then, you “insure” them – sell puts on them – at a price they aren’t likely to drop below.

Since you’re only agreeing to buy the stock below the strike price, you’re safe as long as it doesn’t completely crash. Again, this is why you want to stick with quality companies.

When this strategy is used correctly, you won’t end up buying very many stocks… You’ll simply collect premiums every few months and earn 15% a year or more on your capital.

But it’s no problem if you do end up buying a few stocks. If you follow a few simple rules, you’ll own some great dividend-paying companies at great prices that will compound your wealth for years.

Stansberry Research: You’ve made a convincing case for selling put options. Any closing thoughts?

Eifrig: No other strategy offers a chance to safely profit, no matter what happens to stock prices. I truly believe it’s one of the most valuable investing skills you can learn.

Contrary to popular opinion, I think it’s within reach of any serious investor. It does require some education for most folks to become proficient, but there are a number of free resources available out there. The time and effort you spend learning will be well worth it.

Of course, I invite folks to take a look at my Retirement Trader advisory as well. Our goal is not only to find the safest and most profitable trades, but to educate. In fact, if most subscribers don’t eventually become proficient at finding and making these trades for themselves, I’m not doing my job.

Stansberry Research: Thanks for talking with us, Doc.

Eifrig: My pleasure. Thanks for inviting me.

Summary: Selling puts is a simple way to generate income and potentially “buy” the stocks you want to own, at the exact price you want to pay, while minimizing risk and greatly increasing potential returns.