Puts is a high probability, low gain option income strategy.
option-info and options-graphs sites:
(Cash Secured Equity Put)
Outlook: Mildly bearish to bullish. The position will gain if the
stock rises, stays put, or falls somewhat.
Sell an OTM put.
when: Stock does not fall below the short strike - the credit received.
Gain: Limited to the initial credit.
when: stock falls beyond the breakeven price.
Loss : Unlimited.
Calculation: Short Strike - option credit.
compared to stock: Credit entry, takes advantage of stock that does
not move or moves within a range.
compared to stock: Limited potential gains, possible large percentage
after entry, increasing implied volatility is negative.
after entry, the passage of time is positive.
Requirement : If you have permission from your broker to trade naked
options, the minimum margin is normally 10% of the put strike price +
the put premium, but it can be higher. If the trade is done as a CSEP,
your broker will require you to maintain cash in the full amount necessary
to buy the stock at the strike price. In the example that would be $4500.
Using an ATM strike will bring in a larger credit, but increase your
chances of being put the stock.
Equivalent: Covered Call using
short calls at the same strike price.
- As an
options trader, this strategy might be used if you thought there was
no chance of a stock dropping below the sold strike, and you wanted
to make some premium.
- As a stock
investor, this strategy might be used if you thought the current price
of a stock was too high, but you wouldn't mind owning it if you could
buy it at the strike price. If the stock falls to the strike price or
below, you will be put the stock and you will pay the strike price x
the number of shares represented by the puts you sold.
- The idea
of buying stock below the current market value sounds good at first.
But there is no rule that says when a stock drops it is going to stop
right at the strike price you sold. As a matter of fact, if the stock
drops it could very well go much lower than the strike you sold. Then
your bargain price will not look like a bargain anymore. You would be
buying stock above the then-current market price instead of your original
plan to buy below the current market price.
bull markets, this strategy almost seems too good to be true. You can
make premium with no actual investment, and the stock would have to
fall by a good percentage amount to get you in trouble. The trouble
is, you are actually making very small percentage gains on the amount
of money tied up. And, you never know when a bull market is going to
correct or end entirely. If you make $31 per trade as in the example,
you can make $310 by doing the trade ten times. Then, maybe one time
out of ten the stock drops $4 below the strike price you sold and you
have to buy back the sold put for a $400 loss, nullifying the entire
series of trades.
- If you
are tempted to use this strategy as a CSEP to buy stock below market
value, remember that the only way to gain from owning a stock is if
it goes up. Yet you are agreeing to buy the stock when it is going down,
and you have no way of knowing how far down it will go.
- The graph
of this strategy is the same as the graph of a Covered Call using the
same strike price. You might want to read the Covered
Call strategy page and the Covered
Call Strategies Disadvantages page if you are considering this strategy.
- This strategy
can be used when the Implied Volatility is very high, but you do not
expect a large drop in the stock price. This may be the case when a
stock has had a sharp selloff that you do not expect to continue. With
the IV so high, you can sell the puts for more than normal, which gives
more downside protection and a larger gain if the stock does not drop
too much. The graph below is the same as the example graph at the top
of the page, but the IV has been raised to 70%.
this is a strategy with the potential for only small gains and possibly
large losses, you must control the losses. If the example stock dropped
to $45 at any time, the trade should probably be exited for a relatively
small loss. Trying to hang on could result in much larger losses.
- A trader
can possibly attempt to adjust his way out of a losing short put by
putting the day of reckoning farther out into the future, on more puts.
For instance, if the stock in the example fell to $45, you would have
a loss, but you might be able to roll to twice as many 45 strike short
puts with a month more time left, for about even money.
If the stock recovers you may be able to get out with a small gain,
but if the stock does not recover the adjustments become unsustainable
after a while. You might need to sell 4, then 8, then 16, and so on,
just to avoid taking the original loss. Ask yourself if you want to
be holding 16 short puts during a bear market!
way to try to salvage the trade is by shorting stock if the stock gets
to the strike price. Then if the stock continues lower, the losses on
the short put are matched by gains in the short stock. However, if the
stock reverses you will now have losses on short stock which could easily
wipe out the meager credit you were trying to protect.