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Selling a Deep In-the-Money Put is a very bullish option strategy that has a credit entry.

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Strategy: Deep In-the-Money Short Put

Deep In the Money Short Put Option Graph

The Outlook: Bullish.

The Trade: Sell a deep In-the-Money Put with a couple months or more to expiration.

Gains when: Stock rises.

Maximum Gain: Limited by strike price sold.

Loses when: Stock falls.

Maximum Loss : Limited only by stock falling to zero.

Breakeven Calculation: Strike price sold x number of shares represented - initial credit.

Advantages compared to stock: Tremendously increased leverage, credit entry.

Disadvantages compared to stock: Tremendously increased leverage works to the downside as well, no dividends, limited life.

Volatility: after entry, an increase in implied volatility is negative.

Time: after entry, the passage of time is positive if the stock rises.

Margin Requirement : If you maintain enough cash to buy the stock at the strike price of the short put, your broker will consider the short put to be a CSEP (cash secured equity put), with no further margin requirement. If the short put is considered "naked", then the minimum margin would be 10% of the strike price of the short put times the number of shares represented, but probably more.

Synthetic Equivalent: Long Stock and Short Call at deep OTM strike price. (Covered Call.)

Comments

  • This "stock substitute" strategy takes advantage of the fact that Deep ITM Puts have a very high Delta. This means the Short Put will lose value almost as fast as the long stock would gain value on a rise in stock price. And since you are short the Put, you want it to lose value.
  • Also, since you are selling a Put, the strategy is entered for a credit, instead of the debit that actual stock purchase would require.
  • This strategy should only be used if you are very bullish on a stock. If the stock drops, your dollar losses will be just as large as if you owned stock.
  • You normally would want to sell a put with enough time to expiration for the stock to make the move you expect. In the example, if you estimate that a move from 50 to 60 might take four months, you would use the 60 strike put expiring in four months.
  • The short strike will limit your gains to that strike price. So if you thought the example stock might make it to 75, then you should sell the 75 strike put.
  • One possible use for this strategy is "bottom fishing" without using any cash. If you feel a drop in a stock or index has been overdone, and especially if the implied volatility has risen because of the drop, then you may make good gains with no cash outlay. The higher IV means you will get more for selling the put, which provides a little bit more "downside protection". Always use a stop loss in case your timing is not correct.
  • This strategy can also give very good reward to risk ratios on low priced, beaten down stocks. For instance, you find a company trading at a share price of $1, but you feel this is just a temporary setback and a year from now the company and stock price will recover to at least $10. The low stock price puts a floor under the stock - it can only go down another $1, like a built-in $1 per share stop loss. You sell a 10 strike LEAP put for $8.80. The best you can do is keep the $880 if the stock is over 10 at expiration. The worst you can do is be put to at $10 with the stock at 0, for a $120 loss. Your reward to risk is 7.3 to 1.

Exits

  • This strategy can have dollar losses as large as if you actually owned the stock. For this reason, you should always have a stop loss, just as you would if you owned stock.

Adjustments

  • Because you are short a put, you can have stock put to you at any time, especially if the time value of the short put drops to .05 or .10. This doesn't really cause a problem, since you can then just sell the stock to lock in a gain, and then sell another put if you are still bullish on the stock.
  • For instance, you enter the example trade for a credit of $1063. The stock rises to 58 near expiration, but the time value of the put goes to .05 and someone puts the stock to you at $60, a $6000 debit. You immediately sell the stock for $58, a $5800 credit. You lock in $1063 - $6000 + $5800, or a gain of $863. If you had owned 100 shares of the stock and it went to $58, you would have made only $800.
  • As you can see, the effect of being put to and immediately selling the stock is that you capture the time value you sold, in addition to any gain in the stock price. The $1063 you received for selling the example put included $10 of intrinsic value, and .63 of time value.

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