Beware the Pitfalls of Selling Puts

As I mentioned in the articles about generating income with covered calls and the potential pitfalls with covered calls, I would be remiss if I didn’t mention the potential complications associated with selling puts for income. I think it helps to know what the risks of a particular technique are so that you can make an informed decision as to your overall investment strategy. Some people who are trying to sell you their “system” may gloss over the risks; however, I have nothing to sell and am offering this information free of charge and from personal experience.

For those who missed the article regarding selling puts, let me briefly explain what is involved through an example. Assume you have $15,000 in your brokerage account and wish to invest in Yahoo stock. You feel that the current price of $16.40 per share is too high, but you would take it at $15 per share. You would like to make some money while you wait, so you decide to sell 10 contracts of the July 15 put for $0.40 per share. That means you will receive $400 in your account to add to the $15,000. Your return for 5 weeks is 2.66% which is over 20% annualized. That sounds great, but this is why I am warning you.

Remember the general rule of investing.  The greater the reward, the greater the corresponding risk is likely to be.  Generally, investors are rewarded by taking risks.  The risk in selling puts is that the stock tanks, and you end up paying $15 for YHOO stock while it is trading on the open market at $8.  Now your $15,400 cash portfolio has become worth only $8,400, and you have lost quite a bit.  I was told a story of an investor who was essentially wiped out after the September 11 WorldTradeCenter attacks because he had sold many, many puts and ended up with stocks worth much less than he was forced to pay.  He then had to sell those stocks at a substantial loss to meet margin calls.  Ouch.

Selling puts can be a way to generate some extra income for your portfolio while you wait for a stock to retreat in price.  However, you need to be aware of the risks and realize that a general market decline or a stock specific event can result in a substantial loss.