Beginning Option Strategies/Bullish Strategies

The Principles of Put Selling
Andrea Kramer (akramer@sir-inc.com)

Selling puts is a rudimentary premium-collecting options strategy. (For the ABCs of put buying, click here.)

What is a put? A put buyer has the right to sell shares of a stock at a predetermined price (strike) before a certain time (options expiration). Put purchasers are generally bearish on the underlying equity, and expect the price of the stock to fall beneath the put strike by expiration.

> However, on the flip side of the aisle, writing a put obligates the seller to purchase shares of the underlying security at a predetermined price if the option is assigned. Put writers typically take a neutral to bullish stance on the stock, and anticipate the share price to remain above the put strike by options expiration.

Who should tune in? There are a couple of possible objectives for writing a put. One common goal for employing this strategy is to scoop up shares of an appealing stock at a discount. If the underlying security pulls back beneath the put strike by expiration, the put seller can then acquire the shares (if assigned) at a lower price relative to when he or she initiated the sale.

Meanwhile, likely the most popular purpose of selling puts is to pocket the initial net credit received from the sale. If the underlying stock finishes at or above the put strike by options expiration, the put will expire worthless, allowing the option player to keep the money received at initiation.

(According to Options Clearing Corporation, about half of all options are eventually bought or sold to close, while only about 17% are exercised; the other third or so typically expire worthless.)

How does it work? Assuming the traderís objective is to pocket some premium, he or she would first single out a stock with the potential to remain stagnant or move higher. The investorís anticipated trajectory for the stock should correlate with the put strike, as well as the optionís expiration. In other words, if Trader Tom expects stock XYZ to remain above the $50 level through December expiration, he might consider selling the XYZ December 50 put.

Whatís in it for me? The maximum potential reward for selling a put is limited to the initial net credit received. Since this is the case, potential put sellers should try to single out options with elevated implied volatility levels. If an optionís implied volatility reading is higher than the underlying stockís historical volatility, the option is usually trading at a relatively pricier premium than usual. In other words, selling an expensive option will generate more money at initiation, raising the put writerís maximum potential profit.

What do I have to lose? The maximum risk for writing a put is quite substantial, should the underlying stock fall beneath the put strike by expiration. In this scenario, the put buyer on the other side of the aisle could put the option to the seller, obligating him or her to purchase 100 shares of the underlying stock at the strike price. However, assuming the underlying equity falls to zero, the maximum potential loss can be calculated by subtracting the initial net credit from the put strike.

In order to avoid a loss on the play, the put seller needs the shares to remain above the breakeven level, which is also tallied by subtracting the initial premium received from the put strike.

To reduce the risk of assignment, put writers should consider selling out-of-the-money options, as these optionsí premiums deteriorate at a rapid rate as expiration approaches. Plus, the move required by the stock to place the put in the money is much greater with out-of-the-money puts, as opposed to options closer to the money.

(Donít forget to include any brokerage fees, margin requirements or commission costs.)

Letís look at an example

Meet Evelyn, a newcomer to the options arena. Sheís had her eye on stock XYZ for some time, and thinks the shares will remain above the round-number $100 region Ė home to multiple layers of technical support Ė by December options expiration. Whatís more, Evelyn has noticed a recent spike in implied volatility levels among back-month options, and wants to exploit these pricey premiums by selling a put on the stock.

With Evelynís forecast for the stock firmly in place, she opts to write an XYZ December 100 put, which was last bid at $8. In other words, Evelyn received $8 for selling the back-month option Ė which represents the most she can possibly gain on the play, should the shares of XYZ remain above the $100 level, rendering the put worthless.

If the stock falls beneath this level, the option buyer could then exercise his right to sell the stock, obligating Evelyn to purchase 100 shares of XYZ at the strike price, or $100 each. In this instance, XYZ would be worth less than $100 a share on the market, meaning Evelyn would be obligated to overpay (possibly quite handsomely, depending on how far the stock falls) for the shares.

As such, in order to avoid a loss, Evelyn needs the shares of XYZ to remain at or above breakeven at the $92 level (100 - $8) by options expiration.

Theoretical put sale on stock XYZ

In conclusion

Before embarking on your put-writing journey, there are a few things rookie option traders should note. First, donít sell a put on anything you wouldnít want in your portfolio, as you could be obligated to buy the underlying shares if assigned. Second, make sure the underlying stock has some potential support levels in place, as an unanticipated decline could result in significant losses.

Also, put-selling novices should remember to single out options with elevated implied volatility levels, in order to reap a worthwhile reward. However, keep in mind that time decay is the option sellerís friend, so selling out-of-the-money options may generate a smaller premium than writing their closer-to-the-money counterparts, but the risk of assignment is usually much less.

Finally, while the probability of success for this strategy makes it appealing, itís important to understand the potential risk/reward configuration. The put sellerís maximum potential loss could be quite substantial, should the underlying stock take a significant turn in the red, while the most you can gain on the play is capped at the initial premium received.




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