Option trading can be risky when misunderstood. Thankfully there are a couple scenarios that even entry level investors can utilize to control their risks and increase their returns. Today we are going to be talking about a very basic concept, selling cash secured puts.
To begin with puts can be explained very simply, the seller has an obligation to buy and the buyer has a right to sell at a predetermined price. The seller will receive the premium for the trade while the buyer is the one who determines if he or she wants to sell that stock. Before we get into selling puts, lets understand the other side of the trade. Why would you want to buy a put?
Let’s say I bought Amazon in early 2015 for $370. Now Amazon has been on a fantastic run lately even outpacing most of the market’s returns. It is currently sitting around $1572. I am extremely happy with its performance but after the volatility we have had earlier this year I am worried that the stock market, including Amazon, is going to drop. So, I decide I am going to buy a protective put around $1400. Now each contract is for a hundred shares so I am okay with a loss of $17,200 on my trade because I would still be up over $103,000 in a little over 2 years. Now let’s say that I want to be protected for all of 2018. As of right now the contract price is 84.54 for a January 18th 2019 put contractor. That means I, the buyer, would have to pay $8,454 to cap my loss at $17,200 from today’s prices for the rest of 2018. For my risk tolerance this is an acceptable payment to make sure I don’t lose my shirt in a stock market correction.
Now that we understand the buyer’s mentality of risk protection for buying this put, why would you want to sell this option. The first reason is income. In order to sell this contract, we would need to be able to cover the trade so $140,000 minus the $8,454 premium leaves us with $131,546. That gives us cash on cash return of 6.43% for 308 days or an annualized return of 7.66%. This is interesting if you are predicting a market correction this year and want to move to cash you will still have a return of over seven and a half percent. However, there is still a risk that Amazon could go lower than $1400 and you will begin to lose money on the trade as well. The break even point would be $1315.56, any lower than that and the trade lost money.
Selling Puts to Control Cost Basis
Now I sell puts for another reason, to control my cost basis. Let look at the same example of the $1400 January 18th 2019 put. Imagine I am looking to open a long position in Amazon but I think it is currently trading too high. I have the cash on hand to purchase a hundred shares am long term bullish but short term bearish on the market. In conjunction, I am predicting a correction within the next year between 10 and 15 percent. I decide to sell the aforementioned put and take in my $8454 in premium now while I wait for the stock market correction. Now if it doesn’t come before January 18th I get to keep my premium and decide if I want to open a new position. If it does come and the put buyer decides to exercise their option then I got my long Amazon position at a price that I determined was appropriate plus the premium. Or maybe Amazon keeps increasing and in 6 months I see the option is only trading at $30 so I pay the $3,000 to result in a net gain of $5,545 and look for new positions to open up.
The reason I would suggest new traders try writing cash secured puts is it forces you to check out company’s financials. It makes you try and determine a fair value that you would be willing to pay to own a stock while rewarding your patience with premiums. Selling puts can also be encompassed into several different, more complex techniques such as iron condors, butterfly spreads and straddles. Each has their own risk and reward profile that need to be fully understood before they are utilized. Next time we will get into the basics of buying and selling calls before we begin to explain these more advanced techniques.
Have you had any success selling puts? Or have you been mostly selling calls to generate income? Let me know in the comments below!