The insurance business is a good one to be in.
Need proof? Consider all those skyscrapers bearing the name of insurance companies – like the New York Life building in New York City or the Transamerica Pyramid in San Francisco.
Insurance companies make bets that you won’t get sick, wreck your car or die before they have collected enough premiums from you. Once they do, it will no longer matter to them if you do any of those things.
While that sounds cold, it’s very profitable.
And as an investor, you can do the same thing. You have the opportunity to “write insurance” for speculators or other investors and collect the premium just like an insurance company does.
It’s a conservative strategy that can generate a strong pipeline of income.
Here’s how it works.
Someone buys a stock but is concerned it may go lower. So they buy “insurance” on the stock in the form of a put option.
A put is a bet that the stock will go down. If it does, the value of the put increases, offsetting some or most of the drop in stock price. If the stock goes up, the put expires worthless.
An individual investor can sell the “insurance,” or put, to the other party. Just like an insurance company is obligated to pay a claim after an accident, so is the put seller. But in this case, the put seller is obligated to buy the stock from the investor at a discounted price.
For example, let’s say an investor buys 500 shares of Oracle (NYSE: ORCL) for $56.97 apiece. They don’t want to risk more than 10%, so they buy a put to be able to sell the stock at $51.27 if the price drops. That means that no matter where the stock is trading, the investor can sell it for $51.27.
For that right, they pay $0.55 per share – or $275 for 500 shares. In this example, the contract expires the third week in January. (Option contracts can be bought and sold for various months throughout the year and even a year or two out. They typically expire on the third Friday of the month.)
The $275 is placed in the put seller’s account and can be used immediately for whatever the seller wants – a nice dinner out, a road trip – or saved for a rainy day. The seller now waits for the put option to expire in January.
If the stock closes above $51.27 at January expiration, the put expires worthless. It’s the same as a life insurance premium – if the person is still breathing, the insurance company keeps it. And so does the put seller in this example.
Now, if the stock drops below $51.27, the owner of the put has the right to sell their stock to the put seller at $51.27.
Let’s say the stock is at $50 and the investor “puts” the stock to the seller – exercising their option. The put seller buys the stock at $51.27, but still keeps the $275 or $0.55 per share “premium.” So their real cost is $50.72 per share.
Because of the risk of being forced to buy the stock, a put seller should sell puts only on stocks that they are happy to own at a discounted price.
In our example, if the put seller is glad to buy Oracle at $51.27, they would sell the put (pocketing the premium). And if the stock goes down and they have to buy it, well, that’s just fine because they wanted to buy the stock at $51.27 – back when it was trading at $56.97.
The risk is that a stock falls sharply below the agreed-upon price. So if Oracle was at $48 and the put seller had to buy the stock at $51.27, they are sitting on a sizable loss on paper.
That’s why you should sell puts only on stable stocks that, again – because this is very important – you’re fine with owning at a lower price.
If a put seller could make a similar trade every month, it would be an extra $3,300 in income for the year. Of course, if you have a larger portfolio, you can generate even more income.
You can also generate more income by selling more expensive puts – but be aware that the more expensive the put, the greater the chance you’ll have to buy the stock.
Selling puts isn’t for speculators; it’s for conservative investors who want to generate extra income from their portfolios.
Insurance companies didn’t put their names on tall buildings in expensive cities by making wild bets. They simply collected premiums over and over again, building up a war chest of cash.
By selling puts, investors can do the same. I use this strategy, though the Marc Lichtenfeld building in midtown Manhattan is still a few years away.