An investor usually sells a put option if his/her outlook on the underlying security is bullish. The buyer of the put option pays the seller a premium for the right to sell the shares at an agreed-upon price. If the stock does not trade at or below the agreed-upon price (strike price), the seller gets to keep the premium.
Benefits associated with selling puts
- In essence, you get paid for entering a "limit order" for a stock or stocks you would not mind owning.
- It allows one to generate income in a neutral or rising market.
- Acquiring stocks via short puts is a widely used strategy by many retail traders and is considered to be one of the most conservative option strategies. This strategy is very similar to the covered call strategy.
- The safest option is to make sure the put is "cash secured." This simply means that you have enough cash in the account to purchase that specific stock if it trades below the strike price. Your final price would be a tad bit lower when you add the premium you were paid up front into the equation. For example, if you sold a put at a strike of 20 with two months of time left on it for $2.50; $250 per contract would be deposited in your account.
- Time is on your side. Every day you profit via time decay as long as the stock price does not drop significantly. In the event it does drop below the strike you sold the put at, you get to buy a stock you like at the price you wanted. Time decay is the greatest in the front month.
Suggested Put Strategy Frontier Communications Corporation (FTR)
It finally broke its long term down trend and has been putting in a series of higher lows since May 2012. When a stock puts in a series of higher lows it's usually a bullish development and this is clearly indicated by its strong break out past $4.00, a zone of rather strong resistance.
The $4.00 range, former resistance turned into support will most likely be tested again before the stock trends higher. With that in mind the following strategy could be put into play.
The Jan 2013 4.00 puts are trading in the $0.40-$0.45 ranges. Wait for the stock to trade down to the 4.00-4.10 ranges before putting this strategy into use. If the stock pulls back to these ranges the options should move to the $0.55-0.65 ranges. For this example we will assume that the puts can be sold at $0.55. For each contract sold $55 will be deposited into your account.
Benefits of This Strategy
If the stock trades below the strike price, the shares could be put to your account. In this case, you will have the chance of getting into a stock you like at a much lower price. Your final price when the premium is factored in will work out to $3.45. If the shares are not assigned to your account, you will walk away with a very lofty gain of 15.9% in roughly six months.
Your Potential Risk
The risk is limited if you are bullish on the stock and would not mind owning shares at a lower price. Essentially the risk is the same as buying the shares outright but with the added benefit of getting in at a lower price (via the premium you received) or at least getting paid for trying to. When you put in a limit order, it is either filled or not. If it's not filled you are not paid for your efforts.
If for some reasons you have a change of heart after selling the puts, because maybe you now feel that the stock could trade significantly below the strike price, then you can roll the puts. Buy back the old puts and sell new slightly out of the money puts with more time on them. Your breakeven point in this trade is $3.45.
A suggestion to boost your potential gains
You could take some of the premium you received from the puts you sold to purchase some out of the money calls. This strategy allows you to leverage your position for free as the calls are purchased with the money you received for the sale of the puts. If the stock continues to trend upwards, the calls could significantly rise in value.
Only implement this strategy if you are bullish on the stock, and you are ready for the possibility that the shares could be put to you.
It is imperative that you do your due diligence and then determine if the above strategy meets with your risk tolerance levels. The Latin maxim caveat emptor applies - let the buyer beware.
Additional disclosure: EPS and Price vs industry charts obtained from zacks.com. A major portion of the historical/research data used in this article was obtained from zacks.com. Options tables sourced from yahoofinance.com. Profit and loss chart sourced from poweropt.com.