How would you like to get paid for agreeing to purchase a stock you really like at a lower price than it is today? If you’re thinking this sounds too good to be true, think again, because this is precisely the opportunity when selling a put option.
In this article, I’ll review how to sell put options on TD Ameritrade using the thinkorswim platform. But before I do that, let’s walk through the basics of options trading, why investors choose to trade options, and some of the risks involved.
- What are stock options?
- Why would someone want to sell a put option?
- What’s the catch?
- How to sell put options on TD Ameritrade
- What if the trade goes against me?
- Bottom line
Please note – this article is intended for educational purposes only and is not formal investment advice. It’s recommended you consult with an investment advisor prior to delving into options trading.
What are stock options?
At its simplest, stock options are financial instruments that give an investor the right, but not the obligation, to buy or sell a stock at an agreed-upon price and date. Similar to stocks and exchange-traded funds (ETFs), aspiring options traders will need to open a margin account in order to buy and sell options.
Options are attractive to a lot of investors because they provide leverage. Leverage grants investors the opportunity to accelerate gains (and losses) while requiring only a small amount of up-front capital (i.e. less money out of pocket).
Calls vs Puts
Options come in two forms, calls and puts. A call option is bullish, meaning an investor who purchases a call option is expecting the stock price to go up. On the other hand, a put option is bearish, meaning a buyer of a put option is expecting the stock price to go down.
Similar to stocks, options can be shorted and traded on margin within a brokerage account. (Click here to learn how to short stocks on TD Ameritrade).
Contracts vs Shares
Options trade in contracts whereas stocks trade in shares. When trading options, it’s important to know that 1 option contract equates to 100 shares of stock. So, if I were to sell 1 put option, I’m obligating myself to purchase 100 shares in the underlying stock if certain conditions are met. In such an instance, I need to ensure I have enough cash or margin available to purchase said shares. Or I need to close the position prior to the contract being executed.
Strike Price and Expiration Date
Options are referred to as contracts because they’re truly an agreement between a buyer and seller. The terms of the agreement are outlined by the strike price and contract expiration date.
The strike price of the contract is the agreed-upon price the underlying stock must go above or below to allow the contract to be executed. The expiration date is the date by which the stock price must reach and stay above or below the strike price.
If the stock price doesn’t reach the strike price by the expiration date, the contract expires worthless. In such an instance, the option buyer is out the purchase price of the contract, but the option seller pockets the premium as profit, less the contract fee.
Bid and Ask Price
An options contract trades very similar to a stock in that each have a bid price and an ask price. The bid price is the highest price a buyer is willing to pay to purchase the option whereas the ask price is the lowest price a seller is willing to sell it.
However, when trading options, it’s important to note the bid and ask reflect the price to purchase one share of stock within the contract. Meaning you need to multiply the bid and ask price by 100 to understand the actual price paid or premium received. For example, if the bid price to sell a single put option in thinkorswim is listed as $0.80, the premium I’ll receive for selling said option is $80 ($0.80 x 100) due to there being 100 shares in each options contract.
Volume and Open Interest
When trading stocks and options, it’s important to trade instruments with high liquidity. In short, an option or stock with high liquidity is one that traders can get into and out of very quickly (i.e. when you go to sell, you don’t have difficulty finding a buyer). When trading options, you need to understand volume and open interest.
Similar to stocks, volume shows the total number of options contracts exchanging hands on a particular day. However, volume doesn’t provide any information on whether those contracts were transactions to open or close contracts. Open interest, on the other hand, provides the total number of contracts open at the close of the previous day. You’ll typically want volume and open interest to both be in the double digits to consider opening up an options contract.
Implied Volatility
Investopedia does a good job explaining what implied volatility (IV) is so I won’t discuss in detail here. What’s important to know is, as an options trader, you want to buy when IV is low and sell when IV is high.
Each stock has its own individual IV which can be charted in thinkorswim. As a put seller, you’ll want to ensure a stock’s IV is higher than its historical average so you can collect a higher premium.
Why would someone want to sell a put option?
In short, because they get paid to do so. Typically, there are 2 primary reasons traders and investors sell put options.
The first is to generate income with no interest in owning the underlying stock or ETF. In this instance, traders sell a short put to collect the premium as cash with hope the options contract expires worthless.
The second reason traders sell put options is because they’re hoping to purchase shares in the underlying stock or ETF, but only at a price lower than the current market price. By selling put options, investors collect the premium and get paid to be patient. At some point, the put option may be exercised requiring the investor to purchase shares, but they wanted to buy the stock anyway.
Obviously, there are other reasons investors may sell put options, such as to hedge a position, but these 2 represent what’s most common among retail investors.
It’s all about the premium
Selling a put option is all about collecting a premium and, when all goes as planned, it’s a great way to generate extra income. Typically, selling put options is most profitable during times of high market volatility.
When you sell something, you typically collect cash as payment for the product or good sold. In options trading, the product you’re selling is obligation – you’re contractually obligating yourself to purchase shares in a stock or ETF under certain conditions. By selling this product, you receive payment from the buyer upfront, and if the put contract expires without meeting the specified conditions, you keep the payment.
We’re focusing our discussion here on selling put options for cash, but the same principle applies to selling call options.
What’s the catch?
You may be thinking that selling put options is too good to be true, and that there’s something in the fine print we’ve not discussed. The basics of what we’ve covered hold true, but that doesn’t mean there aren’t relevant risk factors associated with trading options. To the contrary, the risk of loss is real, and trading options is typically reserved for those with a high risk tolerance.
Probably the greatest risk associated with selling put options is a contract being executed at a price well below the strike price. Or what’s referred to as in-the-money.
For example, let’s say I sold a put option with a strike price of $50. When I sold the put, the stock was trading at $60. Between the time I sold the put and the option expiration date, the company reported dismal earnings, resulting in the share price gapping down the following day. Now, the current price of the stock is $40 and I’m contractually obligated to purchase shares at $50. If the option is executed or expires in-the-money, I’m sitting on an immediate 20% loss.
If I really don’t want to purchase 100 shares of the underlying stock, I’ll need to buy back the put I sold or risk a margin call. Because the share price is already below the strike price, the bid price on the put is sure to be well above the price at which I sold it. As a result, buying the put to close the position is going to result in a big loss on the trade, even with the premium included.
How to sell put options on TD Ameritrade
Step 1: Open a margin account
The first step to trading options on TD Ameritrade is to open a margin account. To open a margin account, you need to fund your account with a minimum of $2,000 USD. It usually takes 2 to 3 business days to get approved after submitting the application.
Simply navigate to TD Ameritrade, click “Open new account”, and you’re on your way. Be sure the button is selected to “Actively trade stocks, ETFs, options, futures or forex.”
Step 2: Review the options chain in thinkorswim
Assuming you’ve already identified the stock in which you want to sell a put option, the next thing you’ll want to do is review the options chain. While it’s possible to trade options on TD Ameritrade without using thinkorswim, I wouldn’t recommend it for active traders. thinkorswim is an incredibly powerful (and free) trading platform and traders should take advantage.
The option chain will list all call and put options currently available as well as their strike price, expiration date, volume, open interest, and much more.
To locate the options chain in thinkorswim, click on “Analyze”, enter the stock ticker in the search box, then “Add Simulated Trades.”
Step 3: Select which put option to sell
Put options are located on the right side of the options chain in thinkorswim. For this example, I want to sell an AAPL put with a $130 strike price on the 16 DEC 22 contract. By selling this put, I’m obligating myself to purchase 100 shares of AAPL should the share price drop to $130 or below on or before 16 DEC 22.
To place the limit order, click on the “Bid X” price on the desired contract. A simulated order will be placed in the “Positions and Simulated Trades” section below the options chain.
Step 4: Confirm and send the order
Once the option is in the “Positions and Simulated Trades” section, you can adjust the number of contracts to sell as well as the Bid price. Simply click the plus and minus arrows next to each to adjust the quantity and price.
To place the order, right-click on the contract, then click “Confirm and send”. The following order confirmation box will appear. Click send.
Step 5: Collect the premium
The best thing about step 5 is you don’t actually have to do anything. Once the order is filled, your account is credited with the premium. In the above example, I collected a $155 premium by selling a single 16 DEC 22 put option on AAPL with a strike price of $130.
It’s important to note that my unrealized loss or gain will fluctuate as long as I hold the short put. This is due to the price of AAPL stock fluctuating in conjunction with market volatility. If, come 15 DEC 22, the stock price of AAPL is $132, I’m sure to be sitting on a hefty unrealized loss because the ask price for the short put will be higher than the price for which I sold it. This is because the current share price is a lot closer to the strike price.
However, as long as the share price stays above $130 through market close on 16 DEC 22, I’ll have closed the trade with $155 in profit, and the unrealized loss on my account previously will be gone.
What if the trade goes against me?
Selling put options is great right up until the time it isn’t. In my experience, it usually takes 2 successful put shorts to offset a single bad one, so buyer (or seller in this case) beware.
There are 3 basic options to handle a short put that goes against you, meaning the share price goes (and stays) below the strike price of the contract.
- Buy the put back to close the trade – you’ll take a loss, but won’t be forced to buy shares.
- Roll the contract forward – to roll a contract, you’ll buy back the put you sold, then sell another put on a contract in the future. This will help minimize losses and may even result in a net gain.
- Purchase the shares – if you’re comfortable purchasing shares at the strike price, simply let the contract be executed. Perhaps you’ll be sitting on an immediate unrealized loss, but this may not be a concern if you understand the fundamentals of the company.
Bottom line
Selling put options to collect a premium is another tool to place in your investing toolbox. Be sure you understand the basics of options trading, can interpret the options chain, and are aware of the risks involved. I recommend spending a few hours trading options in a paper trading account prior to jumping in with real money.
When done correctly, selling put options on thinkorswim (the same steps can be performed on the mobile app) is a great way to generate extra income. Or to get in on a stock you really like for a lower price than it’s trading today. All while getting paid to be patient.
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