by Chris Johnson and Jon Lewis | August 11, 2011 11:10 am
Let’s talk about a neutral-to-bullish option strategy that puts money in your pocket right off the bat.
The strategy typically returns in the neighborhood of 10% to 20% (on margin) in less than two months while the underlying stock remains flat, rises, or even falls a bit. What’s more, if the stock declines by more than you expect, you can buy the shares at a discount to the current price.
Though you should naturally be skeptical of such claims, there is such a strategy — put selling, an approach that can be attractive for both options and stock traders. For options traders, it can provide consistent profits, while stock traders can use put selling as a way to get paid while waiting for a stock to pull back to an attractive purchase price.
A put option entitles the buyer to sell 100 shares of the underlying stock at the strike price on or before the expiration date. A put is in the money when the stock’s price is below the strike price. A put buyer is therefore bearish on the stock, hoping that the price will decline sharply so that his option appreciates substantially.
A put seller, on the other hand, is neutral to bullish on the stock and his goal is for the stock price to remain above the put’s strike price. If this happens, the option expires worthless and the put seller retains the entire premium received from the put sale. Another benefit for the put seller is that there is no commission cost to exit a winning trade when the option expires worthless.
We really like this strategy because it has a high success rate and is much more forgiving than straight option buying in that you can be profitable even if the underlying moves somewhat against your expectations. So let’s go over a few put selling tips that should help your bottom line.
For put sells, pick stocks that you wouldn’t mind owning if you had to buy. Remember that put selling is also for those who want to buy a stock at a discount to the current price.
If you want to buy XYZ at $30 and it’s trading at $32, you could sell a 30 strike put, collect the premium, and wait for the stock to decline. If it doesn’t hit $30 before expiration, you keep the premium and sell another put. If the stock moves to $34, perhaps you could raise your “buy” price by selling a 32.50 put. In any case, you’re being paid to wait for the stock to dip to your entry price. Not a bad deal, huh?
On the other hand, don’t sell a put on a stock that you are wildly bullish on. Since a put sell’s gain is capped at the amount of premium received, you’re better off buying the stock or a call option if you anticipate a strong move up. That way you’ll be able to take advantage of the stock’s full move, rather than just a put staying out of the money.
Learn more about selling puts to buy stocks at a discount.
Remember that selling a put obligates you to buy the shares if the put buyer chooses to exercise his or her option. Therefore, if you can’t afford to buy all the underlying stock under your sold put contracts, you should either reduce the number of contracts sold or avoid the strategy altogether.
Since assignment will inevitably occur on some of your positions, make sure that the underlying stock is one that you would have no qualms about owning. Of course, you can close a position early by buying back your put (at a higher price than you sold it). But always be prepared for assignment, since you’re not entirely in control of your position.
Don’t get seduced by higher option premiums, thinking that more premium automatically translates into higher profits.
There’s a reason why premiums are high (or low). Higher premiums usually mean higher expected volatility (the propensity for a stock to move up or down) and declines could be drastic. And that could quickly put you into a steep losing position.
While there is room for error with put selling, it’s still important to have a good handle on the short-term direction to keep your put out of the money.
We prefer to trade only out-of-the-money puts. Why?
The risk of assignment is much lower, they require smaller initial margins, and their premiums deteriorate at an accelerating rate as the options approach expiration. Remember that time decay is your ally when selling premium.
Also, out-of-the-money put sellers can fully benefit from a flat or slightly lower move in the stock. Selling an in-the-money put requires the stock price to increase to move the put out of the money.
When selling puts, focus on short-term options, particularly those with less than two months until expiration.
Because the option-pricing model assumes that price movement is random, the premium per unit of time increases as the length of time to expiration decreases. Thus, the put seller gets more “bang for the buck” with short-term options. Also, the rate of time decay increases as the time to expiration decreases.
Time decay works in favor of option sellers, and the accelerated time decay of short-term puts is optimal.
Choosing the strike price can involve some strategy, especially if the strikes are only 1 or 2.5 points apart. You don’t want to go too far out of the money or the return will be next to nothing. Too close to the money and you risk the option moving into the money.
It’s important that the strike for your out-of-the-money put should be close to a significant support level. Ideally, the strike should be below the support to help keep your sold put out of the money. We like the 50-day moving average, a trend-line connecting a stock’s recent lows, or a strike with a lot of put open interest.
In the event that you are assigned and take possession of the shares after the put moves slightly in the money near expiration, you could benefit from an immediate technical rebound in the stock.
Finally, as with all option strategies, the assessment of the underlying stock is the most critical factor.
Selecting an optimal option strategy is no substitute for successfully gauging the future movement of the underlying stock. Focus on stocks in a strong uptrend with solid downside support.
In keeping with our behavioral valuation approach, look for stocks that are viewed with a healthy dose of pessimism, since such sentiment helps to keep the rally intact. Tried and true support is particularly important, since a put seller benefits far less from a major rally in the stock relative to what can be lost in a major decline.
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