I recently wrote an article describing how you can generate regular monthly income by selling covered calls on shares of stock that you already own. Today I’m going to describe a very similar options strategy, one that also allows you generate monthly income, this time on stocks that you don’t own.

Selling naked puts may sound like something you’d find in the red-light district of New Orleans. But rest assured, this is a time-tested options trading strategy that can provide tidy chunks of income if you target your choices carefully.

Put Some Instant Cash in Your Account Today

When you sell a put, you are selling the right for another investor to “put” shares of a chosen stock to you at a given price on a given date. In other words, you will be forced to buy that stock.

So if I sell a Citigroup (NYSE:C) Dec 30 Put for $2.70, then I am giving another investor the right to sell me his Citigroup stock — which I am obligated to buy — at $30 per share on or before December’s options expiration date. In exchange, I receive $270 (less commissions).

If Citigroup closes above $30 on that date, then not only do I not have to buy the stock, but I get to keep that $270 premium.

If it closes below $30, I will have those 100 shares of Citigroup stock “put” to me at $30. Thus, I’d better have $3,000 in my account in order to purchase those shares. (When you’re selling puts, your broker won’t let you make the trade if you aren’t financially able to take delivery of the shares, should that be the outcome of your trade.)

However, since I received that $270 premium, if Citigroup should close above $27.30, then I’d still come out ahead.

If I do not own any shares of Citigroup at the time I sell the puts, this is called a naked put. It’s different than a naked call, which can result in unlimited losses if the trade goes awry. With a naked put, the most you have at risk is what it would cost if you were “put” the shares, which you know at the time you initiate the trade.

Now that you know the “worst” that can happen with this strategy, let’s take a look at how to make – and keep – money by selling puts.

How to be a Successful Put Seller

Here’s how I’ve generated monthly income off of naked puts, and have almost never had any stock put to me.

First, I choose a stock that I wouldn’t mind owning anyway. Maybe I already have a position, and I’m thinking of adding to it, but I also don’t think the shares are going to take off anytime soon. Perhaps we’re between quarterly earnings reports, and I don’t expect much news until the next report comes around.

For example, I like First Cash Financial Services (NASDAQ:FCFS), which is trading at $41. I wouldn’t mind owning 200 shares, but $41 is a little pricey for me.

So I see that the Dec 40 Puts are trading at $2.39. Now that is a mighty fine premium. I like to generate about 2.5% monthly on option trades, and this one is worth almost 6% for just under two months.

Then, I will sell two FCFS Dec 40 Puts for $2.39 (to represent 200 shares), and net about $471 after commissions.

If First Cash closes above $42.39 on December expiration, I’ll be a little bummed that I didn’t maximize my return by simply buying the stock. If it closes between $40 and $42.39, I come out ahead and still may buy the stock.

If it closes under $40 but above $37.61, then the stock has been put to me and I got it at what I consider a bargain price. And if it closes even lower than that, I’m still happy to have the stock, and now I can cost-average down and buy more if I wish.

Profit from Juicy Put Option Premiums

Another stock with juicy put premiums that I’ve been following for most of the year is J.C. Penney (NYSE:JCP), which has been extremely volatile, but which I consider a bargain below $32. In times of extreme volatility, I’ll sell puts several dollars apart to give me a lot of income, and possibly pick up a few shares at any number of attractive prices.

The same rules apply here as they do to covered calls, as I wrote in my earlier article. Pick a stock you know well and have tracked, have a return target and sell in bulk, and pick stocks that aren’t too volatile especially near earnings.

Lawrence Meyers presently holds naked Dec 40 Put positions in First Cash.