So You Want To Trade Options/Strategies

Two Reasons to Sell Puts
Elizabeth Harrow (eharrow@sir-inc.com)

In this thrilling article, we're going to explore the ins and outs of put selling. Unlike a put purchase, a put sell is generally a neutral-to-bullish position. There are a couple of different reasons why you might take up the selling end of a put trade, so we'll examine which kind of scenarios are appropriate for this strategy. Additionally, I'm going to offer some stern words as to the risks of naked put writing, so you can't claim that I didn't warn you.

Make a neutral-to-bullish bet

First up, let's get this straight: selling a put is the same thing as writing a put. Two expressions, one meaning! You might also hear a sold put referred to as a "short put." Also, in a put selling strategy, you are selling to open, which means you must buy to close (unless your option expires worthless, or unless you are assigned).

sell putsHaving cleared up those lingo-related concerns, we can move on to the nitty-gritty. In a purely speculative sense, you will sell (to open) a put option in order to capitalize on your expectation that the shares will remain above the strike price of that put at least through the option's expiration. In other words, you don't necessarily expect the stock to rally, but you certainly don't expect it to drop. Hence, you are neutral-to-bullish.

For example, let's say that Stock XYZ gapped higher after reporting earnings. The shares have pulled back since, but they've consistently found support at the site of their initial bullish gap. You expect the stock will eventually resume its rally, but you're expecting a bit more consolidation above this chart support during the short term. In order to turn a profit on this expectation, you could sell a put with a strike price that most closely matches with the site of this technical support.

A short put can also be used to take advantage of stocks that are range-bound. Simply sell puts at a strike price that corresponds with the lower rail of the equity's trading range. This type of play is best implemented as the shares are rebounding off support, naturally, rather than pulling back toward it. (In trading, as in life, it's usually not wise to fight the effects of gravity.)

Now, when you decide to pull the trigger and sell a put, you will immediately collect a premium from the sale of the option. This initial premium is your maximum potential profit on the trade.

short-term optionsOnce you've raked in your premium, there are three possible outcomes. In the best-case scenario, your put option will expire worthless, and you'll simply retain your initial credit and walk away a winner. In a worse-case scenario, you might have to buy to close your option, which could either eat into your profits, or potentially even result in a net loss. In the worst-case scenario, you could be assigned, which means you will be on the hook to purchase 100 shares per contract at the strike price of the option. (Of course, this isn't always the worst thing ever -- I'll explain on page 2.)

Since stocks can potentially fall pretty far on the charts, it's easy to see where put selling has gotten its reputation as a risky strategy. If you sell a 50-strike put on XYZ, and the shares then plummet to $5, you're going to swallow quite a loss if you're assigned. Specifically, your loss is limited only by the strike price of the option minus the premium received.

Partially because it's so risky, put selling is best limited to short-term options. On the most basic level, this gives the trade less time to move against you. Plus, the effects of time decay are more pronounced in short-term contracts, and time decay actually works in favor of option sellers. That's because time decay eats away at the price of your option, making it less expensive to repurchase if the trade backfires (all other things being equal, of course).

High implied volatility also works in favor of option sellers, because it translates to a richer initial premium on the sale. Some traders try to pinpoint situations where implied volatility looks over-inflated in order to capitalize on this effect. Of course, once you're in the position, you want implied volatility to drop -- otherwise, your option will be more expensive to buy back, if need be.

Now, having said all of these various things, you should be aware that many novice traders might not be authorized to sell puts. Generally, you must maintain a margin account to run these kinds of higher-risk plays, and you'll likely have to deposit a fair amount of cash to cover your risk exposure before you can sell a put. Be sure to check with your personal broker for the exact limitations and requirements on your account.

Buying stock on a dip

While put selling is a popular way to speculate on neutral-to-bullish price action, there's more to the story. By selling a cash-secured put, you can actually acquire the underlying stock at your desired entry price, all while turning a profit on the sale of the option. Not too shabby, right?

short putsThis option strategy simply makes it easy to follow the old investing axiom of "buy low, sell high." If you're waiting to buy shares on a dip, you can simply sell one put option for each 100 shares you'd like to purchase. Just make sure that the strike price of your option corresponds with the magnitude of the pullback you're expecting -- for example, if you're looking for the stock to pull back from $68 to $64, you could sell a 65-strike put.

Now, simultaneously, you'll set aside enough cash to purchase the appropriate number of shares at the strike price of your option. (This is where the "cash-secured" moniker comes from.) Rather than simply setting aside enough capital to satisfy your predetermined margin requirements, as with a speculative sold put, you'll be stashing away your entire possible liability on the option trade.

As you might have guessed, all you need to do after selling a cash-secured put is wait. Either wait to be assigned, or wait for the option to expire worthless -- I can guarantee that one or the other will come to pass. Sometimes, jocular option players will even refer to this strategy as "getting paid to wait."

As a bonus, you still get to collect a premium on the sale of your cash-secured puts. This initial premium can serve two functions. First, if the stock fails to dip as you expected, and your cash-secured put expires worthless, that initial profit is a reasonable consolation prize. Alternatively, if you do end up being assigned and buying the stock, your premium from the sale of the option can be used to lower your cost of entry on the equity investment.

As you might have noticed, cash-secured puts are substantially less scary than speculative short puts (they even have the word "secure" in their name!). For this reason, cash-secured puts are an appropriate strategy even for the novices among us.

And finally, as promised, a word about naked put writing -- or, the practice of writing puts when you have neither (a) sufficient capital to buy the underlying equity at the strike price of the option, nor (b) a short position in the underlying equity. Simply put, don't do it. In any option-writing strategy, your potential profits are very limited; conversely, potential risk is substantial. Even if you're an expert investor, there's not much to like about those odds.


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