- 1999: Volume 8, No. 5 Put Selling: A Winning Strategy

Put selling is an attractive strategy for both options traders and stock traders. For options traders, it can provide consistent profits. For stock traders looking to acquire a stock on a pullback, put selling is a wonderful way to get paid while waiting for the pullback to develop.

A put option entitles the buyer to sell a number of shares (usually 100) of the underlying common stock at a stated price (strike price) on or before a fixed expiration date. A put buyer is bearish on the underlying equity. On the other hand, a put seller is bullish on the underlying stock. It is the seller's intent to pocket the premium from the buyer, as the option contract's premium will decay to zero if the stock is trading above the strike price at expiration. To see how put selling works, let's examine a put selling recommendation we made recently in The Option Advisor newsletter.

A Case History

On April 23, 1999, with Chevron (CHV) trading at $98.68, we recommended selling the June 90 strike put at $1.65. We used our unique expectational analysissm-a combination of technical, fundamental and sentiment analysis-to generate the trade idea. The stock had recently broken out above the 89 area, which had been acting as resistance since September 1997. Despite the bullish technical strength, analysts in the media were skeptical of the rally in crude oil futures. In addition, a brokerage house had recently downgraded CHV shares.

If CHV shares move higher by June expiration the put seller pockets the full premium, without acquiring the stock. In the example from above, he would pocket $165 for each contract that he sold ($1.65 x 100, the number of shares each contract represents). Even better, he would have collected the full premium without acquiring the stock even if CHV shares stayed flat or declined as low as $90. As long as the shares are trading at $90 or above at expiration, the option would be worthless. It is possible to collect the full premium without acquiring the stock on a modest move against you if and only if the put is out of the money when you initiate the trade. In this case, the CHV put was out of the money by $8.68 ($98.68 - $90) at the time the trade was initiated. This is an attractive feature of put selling and one way to ensure consistency in your options trading. The trade-off is that the premium you collect when you sell puts decreases as you go further out-of-the-money.

What if CHV had declined below 90 at or near expiration? Those who bought the puts from the put seller could exercise their options by selling the stock at the strike price. So the put seller would have to buy 100 shares (for each contract he sold) at a price of $90 (the strike price). The breakeven share price for the put seller on the stock transaction, however, is $88.35 ($90 - $1.65). This is because the put seller keeps the premium that he collected when he sold the put, no matter where the stock goes after the put sell was initiated. The put seller doesn't experience a loss on this exercise unless CHV is trading below $88.35 when the stock is delivered (or put to him). Also worth noting in this particular example is that if the shares are delivered when the stock is trading around the 88 area, the put seller is accumulating the stock at a significant support level.

After assignment of the shares, any profit or loss is unrealized until the shares are sold. If the stock is trading at $89.35 when the shares are delivered, the unrealized profit is one point. And if the shares are trading at 80 when the stock is delivered, the unrealized loss is $8.35. After assignment, the shares can be sold at any time. As it turned out, CHV closed at $93.18 on expiration, so our subscribers profited by pocketing the full premium and never had to acquire the shares.

Assignment: Good or Bad?

There are advantages and disadvantages of getting assigned the stock. If you do not get assigned the shares, one advantage is that you paid only one brokerage commission to complete the transaction. If the majority of the options from your put sell transactions expires worthless (meaning the stock is not put to you), your commission costs will be greatly reduced. On the other hand, if you do take assignment of the stock your potential reward is unlimited, as the stock can move higher forever. But if you get assigned a majority of the time, you will see your transaction costs increase.

Margin Requirements

Put sellers must maintain a margin account. The Federal Reserve Board (FRB) establishes the minimum margin, but some brokerage houses may be more stringent on minimum margin requirements. Currently, the minimum required margin as established by the FRB is the larger of 20 percent of the underlying stock, plus the premium collected, less the out-of-the-money amount, or 10 percent of the stock price plus the put premium. The greater the chance of being assigned the stock, the more the margin that is required. In cases where the stock was not assigned to the put seller, we calculate the return on the transaction by dividing the premium collected by the initial minimum margin requirement. In the CHV transaction, the initial margin requirement was $1,270 for each contract written, as we had to use the first formula to calculate the initial margin. Thus, the return on initial margin was 13 percent ($165/$1,270) in only a two-month period. This is quite a return, considering the stock moved against the put seller by over five points in that period. The minimum margin in your account is adjusted on a daily basis, decreasing as the stock moves higher and increasing as it declines. This is known as maintenance margin. The put seller's risk in the CHV example was having the stock put to him at $90, which was over eight percent below the market value of the stock when the trade was initiated. Therefore, he positioned himself to acquire a stock below the current market value and to profit despite a modest move against him.

Ten Helpful Hints...

1. Do not allow greed to set in by simply focusing on the higher option premiums that extremely volatile stocks command. The premiums are high simply because the stock's expected movement is significant, but this does not necessarily mean that the move over the time period will be bullish or that a big decline will find important support areas. In fact, declines can be drastic, which could corner you into a steep losing position.
2. When writing in-the-money put options, your net premium collected is bigger. However, your margin requirement will be larger, and the chance of assignment will increase. Therefore, your expected capital commitment to a put selling strategy will be greater, as you will likely have more stocks assigned to you. Note also that only out-of-the-money put sellers can benefit fully from flat or slightly lower price action in the stock.
3. You should not be overly exposed to put sell positions. In other words, ensure that you can afford to purchase all the underlying stock under your contractual obligations in the event of a broad market decline, without having to liquidate other assets or longer-term holdings to meet your obligations.
4. While your intent may be to pocket the premium without taking delivery of the stock, you must realize that assignment will happen on occasion despite writing out-of-the-money options. Therefore, you should only implement a put selling strategy on a stock that you have no qualms about owning in the future.
5. When picking the strike price for an out-of-the-money put sell, it is helpful if the strike price is at or near a potential support level. That way, if the stock moves slightly in-the-money around expiration and you are assigned, the equity could experience a technical rebound from which you would benefit.
6. Focus on options with one to three months until expiration. This is due to the fact that in the option-pricing model, the premium per unit of time increases as the length of time until expiration decreases and time decay accelerates in this time period. By focusing on short-term options, the put seller benefits from more attractive premiums relative to the time until expiration and allows time decay to work more in their favor.
7. If you want this to be a less capital-intensive strategy you can improve the odds of not getting assigned by going out another month on the option you sell and going further out-of-the-money.
8. You must have a successful approach for picking the stocks on which you do put sells. If your option pick is correct, but your stock selection is poor, you can still be a net loser in this strategy. We have found success by focusing on stocks in a strong uptrend that are relative-strength leaders and have toned-down expectations.
9. You must fully understand the risks and rewards of this strategy. No matter how much the stock rallies your reward as a put seller is limited to the premium you collect. However, your risk increases with each decline in the stock below the breakeven price before or after the stock is put to you.
10. Do not focus solely on options that have higher implied volatilities than normal for an underlying stock. While this can certainly increase your profit potential, having a good feel for the stock's upside versus downside potential is more important if you are going to be successful. When implied volatilities are significantly higher than normal for no apparent reason, a significant move may be coming. The put seller does not want to be on the wrong side of a major move.

Bernie Schaeffer, Chairman and CEO of Schaeffer's Investment Research, Inc and author of The Option Advisor, founded The Option Advisor newsletter in 1981 and the www.optionsource.com website in 1997.

Mr. Schaeffer received the 1997 "Best of the Best" award from the Market Technician's Association in the field of Sentiment/Psychological Analysis and is a three-time winner of The Wall Street Journal's stock picking contest. He writes a monthly options column for Bloomberg Personal magazine, appears regularly on CNBC, CNN and Bloomberg Television, and is quoted frequently in The Wall Street Journal, The New York Times, Business Week and USA Today.

Todd Salamone, as Director of Trading, oversees the strategic research and analysis supporting Schaeffer's Investment Research's services, newsletters and OptionSource.com content. Mr. Salamone's expertise involves the use of various sentiment indicators to confirm technical trends in stocks and sectors and his comments are often sought by national print media and daily newswires.

They can be reached through www.optionsource.com.