Many uneducated investors think that selling naked puts and renting shares is basically the same strategy. Both are great stock market strategies but they are not the same.
Share renting is when we buy a stock and sell a rental contract on that equity. This gives the purchaser of the rental option the right, but not the obligation, to purchase the stock at a specified price during the contract period. The rental premium is our profit paid up front before we enter the position. For example, we buy a stock for $20 and rent it at $20 strike price for $1.20 we are generating a 6% return or $120 per contract. Our break even price would be $18.80.
Selling a Naked put is when we sell the right, but not the obligation, for the buyer of the put to sell a stock to us, at a specified price, within the contract period. For undertaking this obligation, we also receive a premium upfront. So if a stock is trading at $20 per share and we sell a $19.00 put and receive a return of $0.50 per contract.
On face value the returns a similar with renting shares and if the put is exercised as in the above case we are required to buy the stock at $19.00 but our break even is actually $18.50. This can also be a nice stock market strategy to purchase stocks you are interested in at a discounted or “wholesale” price in the future.
So with a similar break even point some may rightly ask what is the difference, and why buy the stock and tie up capital just to collect the rental premium.
Here are the reasons I prefer covered call writing to naked put selling:
1) Most of the time when you sell a naked put your broker will only allow it if you have enough free funds in your account to purchase the stock if you get exercised. So your investing funds are tied up anyway as if you purchased the stock and rented anyway.
2) The share renting strategy allows more flexibility. The maximum profit a naked put seller can generate is the premium on the option sale, there is also limited actions that can be taken to cover market directions to cover the position. While share renting allows profit from the share renting premium and also any capital gains from stock price increases by renting the stocks “out of the money”. Also if during the contract period the rental premium drops it may be purchased back to close the position early and if the stock price again rises the position opened again gaining more cash flow. The closing and opening of positions with the share renting strategy may occur 2-3 times in a month allowing for much higher returns.
3) With the Share Renting strategy the owner of the stock still receives all dividends or bonuses paid by the company while those stocks are owned, this does not occur with selling puts.
4) The Share Renting strategy allows for the position to be closed early. If a stock price rises then this allows for profits to be taken early. For naked put sellers being assigned early can be a disaster. If the stock price drops dramatically then they may be left with a stock that is way below the price they agreed to pay for it. For example if the stock dropped from $19.50 to $15.00 overnight and continued to drop before the stock had been transferred ownership then you would be left with a large initial loss.
By understanding how the stock market works there are many ways an astute investor can profit. Although the “risk v reward” appears similar for renting shares and selling naked puts, I think an investor who rents their shares has a lot more control and potential to generate more cash flow than selling puts. The two strategies can work hand in hand, you may utilise selling puts to purchase stocks at a wholesale price in the future compared to its current price, while receiving a premium. You may then utilise the share renting strategy to cover any potential upfront losses if the stock price is a lot below the initial purchase price.
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