What are the risks involvd in selling put options as means of earning a regularincome

[clatoden99]

What are the risks involved in selling put options as a means of earning a regular income?

There are many people who claim they are making a good income over the past 2 years selling put options. On further research, I discovered a renown former fund manager Victor Niederhoffer who blew up selling put options. What happened in his case?

How can the risks of selling put options be managed? My experience with stocks is that the most I can lose is the amount I put in. Does this apply to selling put options? The most I can lose is the amount in my brokerage account?

[dczech09]

There is a huge amount of risk being involved in options. I never recommend this as a means of retirement investing, or trying to make a regular income. This is purely speculation and if I cannot talk you out of it, then you should limit it to a very small portion of your finances.

A put option is a derivative security that allows the buyer (aka the "holder") to profit when the underlying stock value goes down. If the underlying stock value goes up however, the seller (aka the "writer") makes the profit.

For example, let's say XYZ stock is currently selling at $50 per share and Sam purchases a put option from you with a strike price of $45 per share and a strike date that is two weeks away. If XYZ stock falls to $40 in that time window, and Sam exercises the option, then you will effectively purchase the stock at $45 per share (but it is only worth $40). Sam would benefit from the $5 spread. If the XYZ stock does not fall below $45, then Sam will effectively sell you the stock at $45 (that is in theory worth more).

Another way that you make money as a seller/writer of options is through the premium for the option. There is a price that the buyer/holder pays to get involved. However, the premiums are smaller when the option is "safer" for the seller/writer. In order to make real money selling options, you need to write some options that have strike prices closer to market (thus they are closer to being "in the money" for the buyer/holder).

As an option seller, you are writing these options and hoping that they do not exercise. If they exercise, you stand to lose a lot of money.

From the sounds of your post, you do not really understand options. That being the case, you should not be playing with them. Options are a great place to LOSE a lot of money REALLY quickly! If you are lucky, you can make a lot too. But you put a lot on the line, and a lot of people have got into big messes with this stuff.

When you sell options, you are not necessarily just playing with money in your brokerage account. You are also on margin (debt). As far as I know, brokerages do require you to have a margin account before you trade options.

Also, keep in mind that a single options contract is worth 100 shares of stock. So in my example above, you are literally betting several hundred dollars at a time.

I took an entire course in college that had to do with options. I aced the class, I know my stuff, and I still steer clear.

[kv968]

dczech09 gave you a very thorough explanation of how options work. I will have to disagree however with his statement that there's a "huge amount of risk" and even that you stand to lose A LOT of money. Don't get me wrong you certainly do if you don't know what you're doing and that's where I feel options get a bad rap by people doing "stupid" stuff without knowing the consequences and then blaming the options themselves as being "dangerous". However if you do know what you're doing you can know EXACTLY how much you are risking and how much you can lose no matter what happens. The word in that case is "spreads".

I trade credit spreads (getting money from writing options like you were asking about) all the time. I may not always make money on every trade (who does?) but I know exactly how much money I can lose on each trade and how to trade around that position as to minimize my loss if need be.

To answer you question on what happened to the person who blew up trading options was that he wasn't properly hedged. And how much could you lose selling put options? Whatever the strike price was on the put you sold. If you sold a $45 put (as in dczech's example) and the stock went to zero you would obligated to buy the stock at $45 so you'd be out $4500 minus whatever premium you received for selling the put in the first place. However had you created a spread and BOUGHT a $35 put with the $45 put you sold you would only lose AT MAX $1000 minus whatever premium you received. How much can you lose selling call options? The sky's practically the limit if not hedged.

Although there's also a different way of looking at selling puts as well and that's using them as a way to enter a stock position (i.e. cash-secured put). Say you want to buy 100 shares of say Facebook if it gets to $100 a share (granted that would be a $10,000 investment, but just for an example). You could put in a limit order at $100 and wait for it to reach that price and if it doesn't you don't buy it. However if you were to go out and sell say the March 18th $100 put (which would obligate you to buy it at that same $100 price) you would receive ~$260 for doing so. So in that case if FB doesn't go below $100 near expiration you don't get to buy the stock (as you wouldn't have in your limit order case either) however you do get to keep the $260. Granted I don't think that's the type of "income generating" you're looking to do but that's another way of using selling to your advantage.

I'll give you an example of what I think you're talking about with a trade I have on right now on SPY (S&P 500)...
Yesterday I SOLD 5 195 call options that expire next Friday and simultaneously BOUGHT 5 196 call options. For that I received $145 (without commissions). So what I'm doing with that trade is putting on a position that says SPY won't be above 195 by next Friday. If that's the case I keep the $145 and walk. However even if SPY skyrockets to say $210 by next Friday the MOST I can lose out of the trade is $355 (without commissions). The reason I can only lose that amount is because I'm hedged when I bought the $196 call. I could have gotten WAY more money by just selling the $195 call all by itself but then I would have nearly unlimited risk and not know how much I could lose. Again, it's all in the hedging.

One thing I will definitely agree with dczech on is if you don't understand options, don't trade them and if you do want to just do it in a simulated account first until you better understand them. And I'm not saying that you need to know EVERYTHING there is to know about options in order to trade them but not knowing what they are, how they perform, what can happen in certain scenarios or shooting for the fences are how people blow up their accounts.

Hope that didn't get you even more confused or discourage you from learning about options because if done right they are a great trading/income generating way of investing. Just learn about them before you dive in.

Any other questions, feel free to ask.