Put options: how to get paid to buy shares

No one likes to overpay for shares. Say you like the look of Vodafone, but you don't want to pay more than 110p a share (the current price is around 114p). What can you do? You could use a 'limit' order and instruct a broker not to pay more than 110p. But even if they fall that far, you'll still pay stamp duty at 0.5% of the purchase price, plus dealing fees.

There's an alternative, says Lee Lowell at InvestmentU.com selling 'naked' put options. It's risky, but get it right and you can end up with the shares you want, at the price you want, plus a bonus in the form of an option premium.

What are put options?

If you hold, say, 1,000 Vodafone shares and then buy an equity put option, you pay an upfront premium to a broker in return for the right to sell those shares at a preset 'strike' price. In effect, you've bought a type of insurance contract. If the Vodafone share price falls, you can sell at the fixed strike price, capping your losses. If it rises instead, you simply keep the shares and abandon the option, which (just like car insurance) expires worthless if it isn't used (or 'exercised') within a fixed period say, three months.

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Better still, options are flexible. The strike price, length of cover and, depending on the stock, the number of contracts bought can all be changed. However, there's a catch: whatever option you buy, and whether or not you choose to use it, you lose the upfront premium. But you could turn the tables and sell options instead.

How the 'naked short put' works

Imagine you want to buy 1,000 Vodafone shares at a maximum price of 110p. You could tell your derivatives broker you'd like to sell (or 'write') a Vodafone put option, expiring in, say, September, with a strike price of 110p. This creates a 'short' position. For this you get an upfront premium of, say, 5p a share, or £50. The word naked (or 'uncovered') describes the fact that you don't yet have any Vodafone shares.

One of two things will happen next. The Vodafone share price may rise from its current level of 114p. If that happens, the option won't be exercised because the holder has no need to sell you 1,000 shares for 110p when they can get more by selling their shares in the open market. That will leave you with £50 for doing very little.

Or the Vodafone share price may fall. Once it drops below 110p the option may be exercised, committing you to pay for 1,000 Vodafone shares delivered via the option. As Andrew Wilkinson notes in Forbes, in practice few options are exercised, but the one you sold might be. But if you were happy to pay 110p for 1,000 Vodafone shares at the outset, you'll now get them, plus £50 on top the nonrefundable premium. And if you change your mind, you can always 'close out' by buying back the option you sold, albeit you may suffer a small loss. What's not to like about that?

The risks

Beware, "selling naked puts is not for everyone", says Kopin Tan on Smartmoney.com. Problem one is volatility as it rises, so do option premiums, which is good news for those selling them. But don't forget that if the Vodafone share price rises far above the option strike price after you sell the naked put, the cost of buying the shares you wanted all along will have rocketed too.

Then there's margin requirements. Selling naked puts can be dangerous (see below) so brokers tend to ask for a high upfront initial deposit (or 'margin'). This is refundable and usually earns interest, but is designed to ensure that you will be able to pay for those 1,000 Vodafone shares if the option is exercised. So never sell naked put options on shares you are not prepared, or cannot afford, to buy.

A warning on options from Nick Leeson

Nick Leeson was the rogue trader blamed for bringing down his employer Barings Bank in the mid-1990s. The bank was eventually bought by ING for £1.

One of his more calamitous trades involved selling multiple naked short put options on Japan's Nikkei 225 stockmarket index. The trades earned Barings huge amounts of option premium income. But there was a big catch. For the trade to work, the Nikkei 225 had to stay above the option strike price, or he would face big losses.

The enormous Kobe earthquake in January 1995 sent the Nikkei spiralling down. Suddenly, Leeson faced huge margin calls on his naked short puts from the Singapore exchange. In an attempt to generate some income, he kept selling Nikkei 225 put options, this time earning much higher premiums thanks to the sudden increase in stockmarket volatility.

But a series of aftershocks saw the Nikkei lurch down rather than bouncing back as he had hoped. These trades contributed to Barings being unable to fund margin calls and to Leeson ending up in jail in Singapore for four and a half years.