Friday, January 21, 2011

Provide Insurance to Other Investors: Generate Income Selling Put Options.

In a stock market environment with inflated prices, the intelligent investor must look for more innovative ways to generate income and increase their wealth.

One method often overlooked is the selling of what are called "put-options." Quite simply, a put option gives the buyer the right to sell a stock at a fixed price and at a fixed date in the future. For example, if John Smith owns shares of CIBC and the current price of his shares are $50, he can buy an option to sell those shares to someone else at $48 six months from now. Why would John do this? Perhaps John owns too much CIBC and wants to just have a little insurance in case the price declines too much. If the shares decline to $30 in six months, John will be very happy that he bought the insurance as he can now sell them to someone at $48. If, however, six months go by and CIBC is still selling at more than $48, John will simply keep his shares and not want to "exercise" his right to sell the shares at $48. His insurance will simply expire.

Of course, John must buy his insurance from someone, and this insurance costs money. Personally, I like to provide this type of insurance on stocks that I would like to own anyway. You could think of it like buying stocks on and getting paid to do it. For instance. If I want to buy CIBC at $48, but it is currently selling at $50, I have two options. I could simply wait until it falls to $48 and then buy it... or I could agree to buy them from John in six months at $48 should he choose to want to sell them, and for this agreement I collect a fee, called an "options premium." The size of this fee changes. The more the owner and myself are worried that the price of the stock might fall in the future, the larger this premium would be.

Now, if agreements like this had to be made on an individualized basis, it would be quite difficult. Thankfully, our modern market economy has what is called an "options market." In Canada, the market is in Montreal at the Montreal Options Exchange. In the United States it is in Chicago at the Chicago Board Options Exchange. The more well known global names will be listed in Chicago, with the domestic Canadian names listed in Montreal.

Now, the "caveat" to this is that you must actually have enough money in your investment account to buy the shares on the date agreed to should the buyer of the put option choose to "exercise," or sell them to you, at the agreed upon price. This seems obvious, but it is important to remember that you cannot simply take your insurance premium that you collected and forget about the contract. You must then provide the insurance that was paid for if it is needed.

This may sound complicated, but the strategy is really fairly simple once you get more comfortable with puts and "options" in general. In the future, I will discuss how money can be made utilizing "call" options. Or the right to buy something at a future date and at a fixed price.

As always, just e-mail me with any questions or concerns : )

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