Selling puts is a neutral to bullish strategy. Traders tend to overcomplicate things. This is especially true with options trading where puts and calls can be bought and sold in seemingly endless combinations with cute names like calendars, diagonals, butterflies, iron condors, ducks, lizards, and so on.
While more complicated strategies have their place, are they necessary to be a successful options trader? No, not at all. Quite often, simple strategies are all that are needed to make consistent profits.
“Everything should be made as simple as possible, but not simpler”. That ironically is a paraphrase of something Einstein said – or is at least attributed to him.
Selling Puts
Buying a put gives the holder the right to sell stock at the strike price to someone else, but only up to the time when the option expires. We might buy a put to have downside protection, i.e., “insurance”, against a decline in the price of a stock we own. We might also buy a put as pure speculation on a decline in price in the underlying. The price paid for a put is a sunk cost that can only be recovered if the put increases in value.
For every put buyer who is long a put, there is a put seller that is short a put. The put seller receives the price, or “premium”, paid for the put. In exchange for the premium received there is an obligation for the put seller to possibly buy shares at the strike price.
Two Simple Rules for Put Selling
- Like the stock
- Like it at the strike price
We should only sell puts on a stock that we would be willing to buy. If we’re willing to buy shares of a stock, why not sell puts on it and buy shares at a discount? Or perhaps just collect put premiums and never actually buy the shares?
We should only sell puts when we think the share price will go up, stay about the same, or if there is a drop it will be relatively small. Here is where Technical Analysis comes in to help us assess the outlook for a stock. We may be looking at an attractive stock that we wouldn’t mind owning, but just as with buying shares, we would only want to sell puts when we’re bullish on the stock at its current price.
Trade Management
There are a couple of possibilities for how to manage a short put trade.
If the underlying share price is above the strike price at expiration, we can simply let the put expire worthlessly. We get to keep the premium collected and our obligation to buy shares ends when the option expires.
If the underlying share price is below the strike price at expiration, we’ll be assigned and must buy shares. Keeping in mind the Two Simple Rules mentioned above, this is not necessarily a bad thing as we can:
- keep the shares for appreciation and dividends (if there is a dividend).
- sell the shares and be done with the position.
- turn around and sell call options against our shares and continue to collect option premium and any dividends.
If the underlying is below the strike price before expiration, there is the possibility of early assignment – at least with American-style options. Some underlying, in particular cash-settled index products, have European-style options that are only exercisable at expiration.
If there is a significant time value left in the put option, an early exercise is unlikely. It would be better for the put holder to simply sell their option if they wanted to exit the position. Otherwise, they would be giving away the time value in the option. But if the time value is small, they may choose to exercise before expiration.
Rolling
As put option sellers, we are in the “business” of selling time value in exchange for taking on an obligation to buy shares at the strike price. If the time value is getting small in a put we sold, we can buy back that option and sell another one further out in time. We can almost always do that for a net credit because we’re selling more time value. Every additional credit we collect by rolling our option further out in time reduces our risk and potential cost basis.
For example, say a stock is trading at $25. We sell a $24 put for 30 days out and collect $1 of put premium. Since we might have to buy shares at $24, our initial risk in the trade is $24 – $1 = $23.
Note that we’re already better off than if we had simply bought the shares at $25.
But suppose the share price dips to $23 and we think we’re likely to get assigned on the put. We could wait for the assignment and buy the shares at $24. We could also buy back the put for a debit and sell one further out in time for a credit. As we are selling more time value than we’re buying back, we should be able to extend the duration on that position for a net credit.
Going back to our example where we sold the $24 put for $1, perhaps we’ve rolled that forward several times, collecting an additional $0.50 credit with every roll. After three rolls, our cost basis on the shares would be $24 – $1 – $0.50 – $0.50 – $0.50 = $21.50. Where we originally thought we liked the shares at $25, by selling puts instead of buying the shares we now own them with a 14% discounted cost basis of $21.50.
Conclusion
After many years of buying and selling options using a wide variety of strategies ranging from the simple to complex, I find that a simple strategy like selling puts can be one of the easiest to manage and most reliable for generating regular profits. Don’t make it more complicated than it needs to be!
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