Want to buy a stock for less?

What if I told you there’s a strategy where YOU pick the price you’re willing to pay for a stock?

Sounds too good to be true, right? Well, it isn’t fantasy. It’s reality.

Back in October, I introduced you to put options. As a reminder, they allow the put buyer to insure their portfolio (by profiting if the stock declines). 

Today, I’m going to explain to you the benefits of selling put options. It’s one of my favorite option strategies because it allows the investor to earn income… and potentially buy a stock at a lower price.

As I’ll show you, this strategy has major benefits… especially if there’s a particular stock you’d love to buy at a lower price.

And the best part? The odds are stacked in YOUR favor. That’s right! Not all option strategies are a long shot…

How a put option works

If you’re new to put options, you should start by thinking of them as a form of insurance…

A put option buyer is like a homeowner who wants to protect their house. They’ll purchase an insurance policy to help cover the costs in the event of damage. And they’re willing to pay the seller a premium upfront for this policy. 

When you sell put options, you’re acting like the insurance company. You’re collecting money (the premium) to insure an asset. 

Now let’s think of the two basic outcomes:

• If no damage occurs, the insurance company keeps the premium as profit. The buyer loses the premium, but is happy nothing bad happened.
• If damage does occur, the buyer has the right to use the insurance to recoup losses on the home. In other words, the insurance company has the obligation to pay for the damages.

Puts work in a similar way. 

When you sell a put option, you collect a “premium” upfront. In exchange, you agree to buy the shares at a specific price—the “strike price”—in the future. The strike price is typically lower than the current price. 

The option’s lifespan depends on the expiration date. Short-term options are usually three months or less, while longer-term options might expire more than a year in the future. These long-term options have a higher premium than their short-term counterparts—you’re paid more for carrying the risk for a longer period of time. 

Going back to our insurance analogy, the insurance company will charge a higher premium for a 12-month policy vs. a three-month policy… and rightly so. 

Keep in mind, selling a put option is a bullish trade. It means you either think the stock is heading higher… OR you want to buy shares at a lower price. In either case, you’re in the bull camp! 

Lastly, it’s worth noting that each option contract represents 100 shares, even though the price is usually shown as a per-share amount.

Let’s look at an example.

Selling a put option on Apple (AAPL)

You can buy or sell put options on nearly any stock. For our example, we’ll use Apple.

In this case, shares of Apple are a bit higher than where you want to purchase it… but you’d be happy to own the stock at a lower price.

Let’s say today is March 14 and AAPL is trading at $100. You’re prepared to own shares of Apple if it falls to $90 anytime over the next three months. So, you sell one AAPL June 19 $90 put option for $3 per contract.

June 19 is the expiration date… and $90 is the strike price. 

Remember when I told you the odds are stacked in your favor? Let’s go over the potential outcomes of this trade example and I’ll show you what I mean.

Here are the four basic scenarios:

1. The stock goes up — AAPL shares keep rallying to $110. In this example, your put option expires worthless and you keep all of the $300 ($3 premium x 100 shares). This is a winning outcome.
2. The stock goes down slightly — AAPL shares fall but stay above $90. Because your $90 strike put is below the stock’s price at expiration, you still keep the $300 without needing to buy the stock. This is another winning outcome.
3. The stock goes down 12% — AAPL shares fall to $88. In this example, your put option expires “in the money” and you are obligated to buy 100 shares of AAPL at $90. But you also keep the $300 in premium collected, so your effective buy price is $87 ($90 strike price minus the $3 premium). This is still a winning outcome compared to simply buying the stock for $88.
4. The stock goes down 30% — AAPL shares fall to $70. In this example, your put option expires in the money and you are obligated to buy 100 shares of AAPL at $90. You also keep the $300 in premium, making your effective buy price $87. Your net loss on this trade is $1,700 (the $70 price at expiration minus the $90 strike price plus the $3 premium). This is a losing outcome, but it’s still better than the $3,000 loss you’d have experienced if you purchased 100 shares of AAPL for $100 and it fell to $70.

As you can see in this basic illustration, the put option seller is at an advantage. Three out of the four outcomes generate a profit for the option seller. You make money from a rising stock price, a flat stock price, and there’s even room for the stock to fall a bit and still result in a profitable trade.

So, what’s the downside? You have to be prepared to own 100 shares at (or below) the strike price. In the example above, if AAPL fell to $30, you’re still obligated to buy 100 shares for $90. That would amount to a $5,700 loss (the $30 expiration price minus the $90 strike price plus the $3 premium). That’s why put options are like insurance—the seller agrees to absorb some of the downside.

Keep in mind, this strategy only makes sense when you’d be happy to own shares at (or below) the strike price. I only sell puts when I’m hoping a stock falls to my strike price.

The bottom line is this: Options can be a great tool for an investor. Knowing how to stack the odds in your favor is how you win the game of investing.

By selling puts on stocks you’d love to own, you’re set to win in three out of the four possible outcomes that I laid out. 

That’s what I call smart investing.

Luke Downey is editor of Curzio's The Big Money Report, which recommends the best long-term growth stocks. Luke honed his strategy over many years at Wall Street institutional derivatives desks, and as co-founder of investment research firm Mapsignals. Luke is also an options instructor with Investopedia Academy.