When put selling makes sense
Chris McKhann | [email protected]
Selling puts generally has a bad reputation, as most of the biggest blow-ups in financial history have come from some form of this strategy. But as long as you avoid the kind of wild leverage that led to those spectacular failures, put selling is well worth considering in the right circumstances.
One example came earlier this month in Cobalt International Energy. A trader sold 4,500 July 17.50 puts for $2.30 with the stock at $17.54. The put seller is generally bullish on the stock, as he or she will profit if CIE is anywhere above $17.50 at expiration in mid-July.
There is the risk of assignment if shares are below the strike price, meaning that the trader could be forced to buy the stock at lower levels. But that risk is often misunderstood and overemphasized.
CIE has dropped below $17 since that trade, so the put seller could be assigned at any time until expiration. But it is important to look at the other side of the equation.
Assignment comes only if there are traders exercising those puts. And I can't think of a reason that a trader would exercise a put that still has that much time value in it, as he or she would lose out on $2 worth of time premium in the options.
And even if the put seller were forced to buy stock, is it really the worst thing in the world? Let's say that someone long the puts did exercise them, and you were randomly assigned. You would lose your short puts and would have long shares in your account. However, you would have bought the shares for $17.50 and collected $2.30 from the put sale, translating to an effective purchase price of $15.20.
You could then immediately sell the stock for roughly $17, which would still leave you with a profit of about $1.80 on the trade, minus fees and commissions. That isn't a bad profit for a week.
Some traders actually use short puts with the intent of buying stock in exactly this way. They sell at-the-money or even in-the-money puts, hoping to get assigned. Others sell out-of-the-money puts on stocks they would like to purchase on a pullback. These types of trades are always "cash secured," requiring the put sellers to have enough money in their accounts to buy the stock if assigned. This is also the way that you can sell puts in an IRA.
It may seem difficult to do well with such a trade, given the lack of leverage. But of all indexed strategies, put selling performs the best. The CBOE PutWrite Index not only outperforms the S&P 500, but it also does so with significantly less volatility--and that includes both 1987 and 2008.
I am not recommending that put selling should be your primary option strategy, but it is well worth understanding and possibly adding to your arsenal of trades.
(A version of this article appeared in optionMONSTER's Advantage Point newsletter of Dec. 11.)