A strategy idea for options trading investors.
Short puts are a staple options strategy I continually employ on cheaper stocks presenting bullish opportunities. They provide a higher probability of profit than owning stock outright and offer a risk/reward profile identical to the ever popular covered call trade. The fact that short puts profit from time decay adds yet another element to their appeal. One of my more recent short put suggestions was on the ProShares UltraShort 20+ Year Treasury ETF (NYSE: TBT) included in the June 30th post Bond Drop Means Rally in TBT Inverse ETF. Despite the higher probability of profit, traders must not forget that short puts have the potential to result in large losses. To fulfill the all important mandate of minimizing losses, it is imperative that traders develop a game plan for managing short puts that run amiss. Here are three of my own techniques of choice.
Broken Support
Perhaps the simplest technique is to exit the trade by buying to close the short put option once the stock breaches a technical support level. More times than not the breaking of a support level is followed by a continued fall in the stock price. In TBT, the $32 level is a key line in the sand which has been successfully defended by the bulls multiple times over the past six weeks (see chart below). If TBT falls below this level traders may consider closing any short put positions to eliminate the risk of additional losses.
Roll Down
Rolling down consists of buying back the put option you originally sold and selling a new put option with a lower strike price. An example would be buying to close the TBT Aug 33 Put while selling to open the TBT Aug 31 Put. This adjustment accomplishes three primary things. First, it reduces the directional exposure of the position (also called the position’s delta) so that if the stock continues falling the losses won’t mount as quick. Second, since the new put option is further out-of-the-money the probability of profit is enhanced. And third, it allows the trader to maintain some type of bullish exposure so that if the stock does rebound they will be able to recapture some, if not all, of the current loss.
When rolling down I typically stick to the same expiration month if there is sufficient time remaining. Since there are still four weeks remaining in the August cycle we could roll the Aug 33 put to an Aug 32 or 31 put if desired. There is no need to make the jump to September options just yet.
Covered Call
When traders sell a put option they obligate themselves to purchase shares of stock at the strike price. If you sold the TBT Aug 33 put option, then you would be obligated to purchase 100 shares of TBT at $33. If you didn’t mind getting long shares of stock you could simply allow assignment if the put option resides in-the-money at expiration. Following assignment you may then consider selling covered calls against your position. This is often why short puts are referred to as the front end of a covered call.
Each of three techniques discussed today has their own inherent trade-offs. Identifying the best course of action for minimizing losses really comes down to personal preference.
Source: MachTrader
At the time of this writing Tyler Craig was short put options on TBT.
Follow Tyler Craig on Twitter@TylersTrading.
