One way to generate extra income for your investment portfolio is to sell put options and collect the premiums.

Ideally, the put will not be exercised and will simply expire worthless.

Even if the stock moves against you, you can always buy the same option to close your position in order to cut your losses. It helps to sell puts against a stock you like and pick a strike price at which you would not mind buying the stock anyway. This way, even if the put is exercised, you end up with a stock you like at a discount.

When Things Go Very Bad

However, there are rare times where the underlying stock could fall sharply overnight—say, 30%. You wouldn’t even have a chance to act before the stock has made a big move against you. What’s worse, you probably wouldn’t have wanted to buy the stock at the strike price if you had known whatever new information caused the huge drop. In this scenario, you would end up stuck with a stock you no longer want and you would probably be sitting on a sizeable loss on the position.

This is a drawback to selling options (calls and puts). No matter what the stock does, your upside is limited to the premium you collect but you could suffer a big loss if things really go against you. However, the flexibility of options enables you to manage your risk and limit your risk.

Bull Put Spread

Let’s look at an example of how using two put options can limit the potential downside.

The strategy we will discuss is called a bull put spread.

To execute this spread, in addition to writing the put as normal, you also buy a second put with the same expiration date but lower strike price.

Since you also buy a put, the cost of that second put reduces the net premium you receive, but it limits your potential loss on the downside.

How It Works

Let’s use Shopify (NSDQ: SHOP) to illustrate how a bull put spread would work using real market prices.

Let’s say despite the stock’s volatility, you think that the solutions the commerce company offers globally position it for strong growth in the long run. You think it’s a good buy at $35. Instead of just buying the stock, you decide to sell (write) three March $35 put for $4.54. You collect $1,362 in premium ($4.54 x 3 x 100). I am ignoring the negligible commission cost to keep things simple.

You know that the stock is volatile and the company is economically sensitive, and you think that if the stock fell below $28, it would mean something is really wrong. You want to protect yourself just in case. You buy three March $28 puts at $1.86 for a total cost of $558 ($1.86 x 3 x 100). This leaves you with a net credit of $804 ($1,362 – $558).

Limiting the Downside

Had you only wrote the $35 put, and SHOP fell to $20, if you didn’t manage to close the position in time you would lose $3,138 ($4,500 – $1,362) on the trade. Things would be even worse if SHOP drops more than that. However, since the long put gives you the right to put SHOP to someone else at $28, no matter how low the stock goes, you will be able to sell it at $28.

Therefore, your maximum loss is limited to $2,100 (stock put to you at $35, but you put to someone else at $28). But since you have a $804 net credit, your maximum loss would decrease to $1,296.

Thus, the spread caps your maximum loss at $1,296 and your maximum gain is $804.

When the Stock Is Put to You

If SHOP was between $28 and $35 at expiration, the long put position would expire worthless and the short put position would be exercised. If you held both legs of the spread to expiration, you will end up with 300 shares of SHOP.

Keep in mind that in our example you didn’t mind buying SHOP at $35 in the first place and you only get concerned if it dropped to $28 or worse.

If the stock dropped to $32 and the stock was put to you, you wouldn’t mind so much. This is because if you had bought the stock instead of doing the bull put spread, you would have bought SHOP at $35 anyway. By writing the put, you lowered the cost of buying the stock.

If you end up with 300 shares of SHOP, you can decide to sell them right away. Since you considered buying the stock in the first place, you probably want to hold for a bit. For the time being, you can even generate additional income by writing calls against SHOP and collecting premiums that way.

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