Selling puts is comparable to covered calls in terms of market risk, but with some notable differences.
Rolling flexibility. The short put can be rolled to any later-expiring strike without consequence. In comparison, rolling a covered call has to take into account the potential of exercise and resulting capital loss on the underlying.
Dividends Stock ownership includes earning dividends, so covered call writers have three forms of income (dividends, option premium, capital gain). In comparison, put sellers get no dividend or capital gain.
Cash outlay. You can but stock on 50% margin and further reduce outlay with a covered call. In comparison, selling an uncovered put requires collateral of about 20% of strike value. To calculate exact margin requirements, go to the free CBOE calculator, at CBOE Margin Calculator
These pro and con arguments point out the problem of choosing covered calls or uncovered puts. However, some put selling takes place on the theory that profits are easy. The thinking goes like this: The put is selected to consist mainly of non-intrinsic value, so time decay will quickly erode the premium. This is true in the last month of the put’s life, and the premium does buffer the risk. It is even possible to buy to close the short put and earn a profit even if the stock declines below the strike.
So the idea here is that put selling is an easy way to exploit time decay and earn a profit. As an alternative to just buying stock, the rationale is that you were going to buy shares at the strike, even with the risk of price decline … so selling the put has no higher risk. Some of the time, you keep the proceeds because the put expires worthless; and some of the time, stock is put to you below market value. So the outcome between buying shares and selling the put is the same in some cases, and advantageous in others.
This is a flawed outlook, however. Why sell the put and accept exercise with the rationale that you wanted the stock at that price? This makes no sense based on the subsequent price decline. Anyone would prefer to buy shares at a lower price, and are not likely to shrug off the loss acquired through an assigned short put. If the stock price declines rapidly, the paper loss can be substantial, meaning recovery is remote and potentially time-consuming. In this case, you end up with a portfolio full of paper losses due to put selling gone bad.
Selling uncovered puts is a strong strategy that may belong in some portfolio plans, but the position has to be monitored closely. Combined with selection of underlying issues based on strong fundamentals, the timing of an uncovered put also should be based on technical signals. These include a long-lasting and strong support level (for example, after a flip from resistance and several failed tests of support). Another method for testing price strength is to track momentum through Relative Strength Index (RSI). The most reliable test of all is Bollinger Bands. Time entry using the standard default of two standard deviations; better yet, adjust to three standard deviations to identify great timing for exceptional returns from short puts. For example, Bristol Myers Squibb (BMY) yielded four strong signals at close to the same point indicating excellent timing for opening short puts.
On this chart, the first significant price behavior was a huge gap, moving down six points in a single day. This was accompanied by a large volume spike and movement of RSI into oversold. The gap took price below the 3-standard deviation Bollinger Bands, an extreme move rarely seen. It is unlikely for price to remain at this position for long. Even so, with price moving back into Bollinger range, it continued declining.
The final confirmation signal was a bullish reversal, the candlestick known as a three inside up. This normally will be found at the very bottom of a downtrend. This signals timing for a bullish move. Long calls might work well in this situation, but in order to profit even with rising prices, you have to fight time decay. A short put, in comparison, benefits as expiration approaches. When this many signals converge at the same time, confidence should be high for timing of short puts.
No matter how many bullish signals you find for a stock price, there are no guarantees. These are only methods for increasing the odds in your favor, but even the strongest signals fail some of the time. Short puts contain the same market risk as covered calls; and like all strategies, once entered they have to be monitored closely. Establishing your exit point, based on percentage yield or price activity, is essential to set up profits consistently. Another wise idea is to determine in advance when to bail out and take a loss, if and when the position moves against you.