Selling a Put
- Extremely highly implied volatility (the higher, the better)
- There is an identifiable support level
- You want to own the underlying security
Once this trade is entered, one of three outcome will occur:
- The stock will remain above the strike price of the put option and the option will expire worthless. In this case the writer of the option keeps the entire premium he or she originally collected when the option was written.
- The price of the stock will fall below the strike price of the option written, the option will be exercised, and the writer of the option will be assigned (ie, required to purchase 100 shares of stock at the strike price).
- The writer of the put option will buy back the option before outcome 1 or 2 occurs.
This strategy is used by investors who are interested in accumulating shares of stock in a particular company but who for one reason or another are not willing to commit to buying the shares at the moment. It is best suited for value investors who typically accumulate a position of meaningful size in a stock after the stock declines in price and are willing to hold the position for a reasonably long period. The most important consideration is whether you want to own the stock when you execute this trade. If the answer is no or if you are not really sure, you should not use this strategy. To understand why, let’s consider the primary benefit of this strategy and the worst case scenario. Investors who use this strategy do so in an effort to acquire stock at a price below the current market price. Here is how that happens.
Say a stock is trading at a price of $85 per share. At the same time the 80 strike price put option is trading at a price of $3. You could buy the stock at $85 per share or you could write a put option with a strike price of 80 and collect a premium of 3 points or $300. If you buy 100 shares of stock at $85 per share and it declines to $77 per share, you will lose $800. If you had written a put option at a strike price of 80 for 3 points and the stock declines to $77 per share, you would be at break even. This is the benefit.
The disadvantages are:
- If the stock rallies sharply, you will not participate in that rally beyond the option premium you collected.
- If the stock falls sharply, you will have significant downside risk.
You should use this strategy only after you have analyzed the prospects for the underlying company and have consciously decided that you are definitely willing to buy the stock. Use this strategy only when volatility is high to maximize the premium you receive for the option you write.
One method for managing stock position if assigned when the stock is put to us and its price continues to decline. You can hold the position until the option expires or the stock is put to you. If the stock is put to you, you can place a stop loss at the strike price less the premium. Or you can sell call once it is put to you.
Writing a Covered Call/Sell Call
- You have some reason to expect the underlying to pause.
- Option volatility is high
- You can take advantage of time decay by selling out-of-the money options
Option offers to long term investors the ability to hedge existing positions in an underlying security. If you are holding position in a stock and wants to hedge that position, options are often the easiest and most effective alternative for achieving this objective. A covered call write involves writing a call option against a long position in the underlying security.
Covered call is most commonly misused option strategy. Most traders never consider writing covered calls, once they do, they rarely stop to consider the reward and risk ramifications. At best, writing a covered call allows income generation from an existing position and to obtain a little downside protection. At worst, this strategy limits your upside potential and provides only a limited amount of downside protection. There are a number of different ways to use this strategy. For instance, some traders buy a stock they consider oversold and simultaneously write a call option against that position. This is referred to as a buy-write and is employed by an investor who is focused on total return. Or you can write options against stocks you already held. Use this strategy after a security you are holding has experienced a significant rally and you expect it to consolidate or decline in the near future.
In sum, if a security you are holding has experienced a sharp advance in price and implied volatility rises to a very high level, thus inflating the amount of premium available to option writers, you may benefit from writing a covered call.
In deciding how to manage a covered call position, you must address two risks:
- The first risk is that the stock may fall by more than the amount received when the call option was written. Once that happens, the covered call provides no additional protection, so the potential loss becomes unlimited. Technically the risk is not unlimited since the stock can only go to zero.
- The second risk is that the stock may rally sharply, causing the option that we wrote to trade in the money. Once the option trades in the money, there is a possibility that the holder of the option may exercise the option and our stock will be called away. If we do not want to give up our stock position, we must plan to buy back the call if the stock price rises.
Before writing a covered call, you must decide what you will do if the stock drops sharply or rallies sharply. If the stock drops sharply, your choices are these:
- Sell the stock, buy back the call, and exit the trade completely to avoid additional losses.
- Hold on both positions and hope the stock bounces back
- Roll down. Rolling down involves buying back the call option written initially and selling a new call option with a lower strike price.
If stock rallies sharply, you may do one of three things:
- Let the stock be called away
- Buy back the call option you wrote (possibly incurring losses)
- Buy back the call option you wrote and sell another further out of the money call option
There is one way around the limited profit potential conundrum that offers the benefits of covered call writing while allowing you to participate in favourable movement by the underlying: avoid writing covered calls in a 1:1 ratio. You need to have more than 1 contract to do this. If you are holding 1000 shares of stock, you might consider writing 8 call options instead of 10. By doing so, you will still have option premium which offers some downside protection and opportunity to earn extra income.