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 for Citigroup, Inc. (C)
The stock has put in a nice double bottom formation, broke past resistance in the 28 ranges and has managed to trade above its downtrend line. As long as it does not close below 24.60 on a weekly basis the outlook will remain neutral to bullish. As long as it manages to stay above 28, the short-midterm outlook will be bullish and it has a good chance of trading to 32-33 ranges before pulling back. In the short term it could test the 28 ranges again, former resistance turned into support before trending higher.
Ideally, one should wait for a test of the 28 ranges before selling puts. We are going to look at the Jan 2013, 29 puts, which are currently trading in the $2.81-2.84 ranges. If the stock pulls back to the 28.00-28.50 ranges, these puts should trade in the $3.00-$3.10 ranges. For this example, we will assume that the puts can be sold at $3.00. For each put sold, $300 will be deposited into your account. You do not have to wait for the stock to pull back to the above stated ranges to put this strategy to use. You could sell these puts immediately. So why wait? Note it took several attempts for it to trade above and trade above $28.00. On the same token it's likely to test this former zone of resistance turned into support a few times before trending higher. It is for this reason we are suggesting that individuals wait until this comes to pass before putting this strategy to use.
- You have the chance of getting into a stock at a price of your choosing. If the stock trades below the strike price, the shares could be put to your account. Your final cost per share will be $26.00.
- If the stock does not trade below the strike price you get paid for your efforts. In this case it works out to a gain of 11.5% in roughly 6 months.
- As a reminder only put this strategy to use if you are bullish on the stock and prepared for the shares to be put to your account.
- As long as you are bullish on the stock and are open to the possibility that the shares could be assigned to your account, your risk is limited. Essentially you are taking on the same level of risk as you would if you bought the shares outright, but with the added benefit of getting in at a lower price (via the premium you received). When you put in a limit order, it is either filled or not. If it's not filled you do not get paid for trying.
- If you have a change of heart after selling the puts because 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 $26.00.
A suggestion to boost your potential gains
Take some of the premium you received from the puts you sold to purchase some out of the money calls when and if the stock trades to the suggested ranges. For example, you could purchase the Jan 2013, 33 calls. Using the money you received from the puts you sold provides you with the chance of leveraging your position for free as you are not paying for the calls.
This strategy should only be implemented if you are bullish on the stock as there is a chance that the shares could be assigned to your account. The benefit of this strategy is that it provides you with the opportunity of getting into a stock you like at a price of your choosing or getting paid for your efforts.
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. Option profit and loss graph sourced from poweropt.com
Disclaimer: 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