Put Strategies

There are five popular strategies for selling puts: to produce short-term income, to make use of idle cash deposits in a brokerage account, to buy stocks, to cover short stock positions, or to create a tax put.

Strategy 1: Producing Income

The most popular reason for selling puts is also the most apparent: the purely speculative idea of earning short-term profits from put premiums. The ideal outcome would be a decline in put value from falling time and intrinsic value, enabling you to purchase and close the short position at a profit.
Time is on your side when you sell, so the more time value in the total premium, the better your chances for profit.

Example

The Put Time Strategy: Last January, you sold a June 45 put for 4. At that time, the underlying stock's market value was $46 per share. Because market value was higher than the striking price, the entire premium was time value. (For puts, in-the-money is opposite than for calls.) If the stock's market value remained at or above $45 per share, the put would eventually expire worthless. If by exercise date stock is valued between $41 and $45 per share, you would earn a limited profit or break even in the event of exercise (before trading costs). The $41 per share level is 4 points below striking price, and you received $400 for selling the put.

A short position can be canceled at any time. As a seller, you can close the position by buying the put at the current premium level. However, the buyer has the right to exercise the put at any time. So when you sell a put, you are exposed to exercise if that put is in the money (when the stock's market value is lower than striking price). For the premium you receive, you willingly expose yourself to this risk.

You can make an informed decision about short puts by being aware of the profit and loss zones in any open positions. From this analysis, you are able to decide in advance at what point to close the positions or how long to keep them open. This self-imposed goal is related to premium level, the status of current market value in relation to striking price, and the degree of time value premium remaining. If a profit becomes unlikely or impossible, you have the choice of closing the position and accepting a limited loss.

Smart Investor Tip

Options traders recognize that they cannot be right all of the time. It often is wisest to accept a small loss rather than continue to be exposed to potentially greater losses.

[caption id="attachment_12502" align="aligncenter" width="380"]Put selling profit and loss zones. Put selling profit and loss zones.[/caption]

An example of profit and loss zones for selling a put is shown in Figure above. This is based on a striking price of 50 with put premium of 6. The premium creates a six-point limited profit zone between $44 and $50 per share and a profit zone above striking price. Below the breakeven point of $44, you will experience a loss. This visual range analysis helps you to define when and where you will close a position, based on proximity between a stock's current market value and loss zone.

It is possible to close the put at a profit even when the stock's market value falls below striking price. This relies on time value decline. The analysis of profit and loss zones in Figure is based on the worst-case assumption about where a stock's price will end up at the point of expiration. If the premium contains a good amount of time value, you can profit merely by trading in the put, even when considerable price movement occurs. Of course, whenever it moves to an in-the-money range, you also risk exercise.

Conceivably, you could select stocks that will remain at or above the striking price and earn premium profits repeatedly, without ever experiencing exercise. However, foresight about which stocks will achieve such consistent price support is difficult. It takes only a single, temporary dip in price to be exposed to exercise, a risk that cannot be overlooked. Exercise is not necessarily a drastic outcome, but it does tie up your capital because it requires that you buy stock above current market value. While you wait for the stock's price to rebound, you will miss other market opportunities.

Remember the basic guideline for selling puts: you need to be willing to buy 100 shares of the underlying stock at the striking price, which you consider a fair price for that stock. If current market value is lower than striking price, you should believe that the price is going to rebound, justifying the purchase you will be required to make upon exercise. In other words, work with stocks you consider worthwhile long-term investments.

This does not mean you would necessarily welcome exercise. It only means that you would not mind buying those shares at the striking price. You might still want to avoid exercise whenever possible by rolling positions, remembering that exercise of many puts means you may end up with a portfolio of overpriced stocks.

Example

Poor Programming: You sold several puts in the past few months. This month the entire market fell several hundred points. Five of your puts were exercised at the same time, requiring you to purchase 500 shares of stock. All of your available capital now is tied up in these shares. Consequently, your portfolio's basis is higher than current market value for all of the shares you own. The market is recovering, but very slowly. Even considering your premium income, you are in a large paper loss position. You have no choice but to sit out the market and hope for a rebound in the future.

The net cost level for stock acquired through exercise of puts is the striking price, minus premiums you received when you sold the puts. Allowing for transaction fees paid (both when you sold the put and when you bought the shares), your basis will be higher still. You should not overlook the potential paper loss position you could experience in the event of a broad down-trending market. You may recover this paper loss position by selling calls on the stock you have acquired, but you also have to be careful with that strategy. Be sure that if the calls are exercised, you will not go out of the long position with a net loss. Chances are that in the event of a large market decline, you will need to wait out a recovery before making any further decisions.

Strategy 2: Using Idle Cash

When you sell options, your broker requires deposits of cash or securities. With puts, the maximum risk is identified easily. It is equal to the striking price of the put. If the short put is exercised and you are required to buy 100 shares, the firm needs to ensure that you have cash or securities available to honor the purchase.

You may hold your capital on the sidelines, believing that stocks you want to buy are overpriced and will be more attractively priced in the future. The dilemma is that the longer cash is held in reserve, the more you miss opportunities to put that money to work. Idle cash does not earn money, and there is no way to know how long it will take for conditions to present themselves, making the desired move practical.

One way to deal with this problem is by selling puts on the targeted stock. In this way, capital is still kept in reserve, yet you earn money from put premiums and you discount the basis in the stock in the event of exercise. You will profit from selling the put if the stock's price rises; and you will end up buying shares at the striking price (less premium discount) if the stock's market value falls. In either event, the premium you receive will be yours to keep.

Example

Planning for a Correction: You are interested in buying stock as a long-term investment. However, you believe that the current market price is too high, and that a correction is likely to occur in the near future. One possible solution: Sell one put for every 100 shares you want to buy, instead of buying the stock. Place your capital on deposit with the brokerage firm as security against your short position in the puts. If the current market value of the stock rises, your short puts will fall in value and can be closed at a profit or allowed to expire worthless. In this way, you benefit from rising market value without placing all of your capital at risk.

If market value of the stock declines, you will purchase the shares at the striking price. Your basis will be discounted by the amount of premium you received for selling the puts. As a long-term investor, you will be confident that the share price will grow over time, and the current paper loss will be partially offset by the premium.

One aspect of this approach that is troubling is the possibility of lost opportunity. If you are wrong in your belief about a stock and its market value continues to rise, selling puts brings some income, but you pass up the chance to buy stock. So when you sell puts as an alternative to buying shares outright, you also need to accept this risk, or to mitigate the risk in other ways. For example, many combination strategies provide the chance to reduce lost opportunity risk while continuing to sell short options. Combined Techniques: Creative Risk Management explores combination techniques in more detail.

Strategy 3: Buying Stock

The third reason for selling puts is to intentionally seek exercise. Selling a put discounts the basis in stock in the event of exercise, and when seeking exercise, you will not be concerned with price drops in the stock.

Example

Putting It Another Way: You have been tracking a stock for several months, and you have decided that you are willing to buy 100 shares at or below $40 per share. The current price is $45. You could wait for the stock to drop to your level, which might or might not happen. However, an alternative is to sell a November 45 put, which has a current premium value of 6. This is all time value. If the market value of stock rises, the put will become worthless and the $600 you received is yours to keep. You could then repeat the transaction on the same argument as before, at a higher price increment. If the stock's market value falls below striking price, the put will be exercised. Your basis would be $39—striking price of 45 minus six points received in put premium—or $1 per share below your target purchase price.

In this example, the put was sold at the money and the premium—all time value—was high enough to create a net basis below your target price. Even if the stock's market value were to fall below $40 per share, your long-term plans would not be affected. You considered $40 per share a reasonable purchase level for the shares. As a long-term investor, you are not concerned with short-term price changes. Simply waiting for the right price to come along means you expose yourself to the risk of losing the opportunity to get the stock at your price. Selling puts discounts current market value and makes it worthwhile to wait for exercise, especially if you believe the current market price is inflated. For example, if a broad-based market rise has resulted in the stock's price rising quickly, the timing for the option position could be good. If time value is high in the put you're thinking of selling, it is a better alternative than buying shares of stock.

Example

Reduced Basis, Nicely Put: You are interested in buying stock at $40 per share. Current market value is $45. You sell a put with a striking price of 45 and receive 6. Willing to take exercise, you reduced your potential basis to $39 per share by selling the put. However, instead of falling, the stock's market value rose 14 points.

In this scenario, the put will expire worthless and you keep the $600 as profit. But if you had bought shares instead of selling the put, you would have earned $1,400 in profit. However, once your put expires, you are free to sell another one, offsetting the lost opportunity and perhaps exceeding that potential profit over time. The lost $1,400 is easy to recognize after the fact; however, at the time of making the decision to sell a put, you have no way of knowing whether the price will rise or fall. If share price were too high, you could risk losing $1,400 just as easily as you miss the opportunity for profiting by the same degree. This is why selling puts sometimes presents an attractive alternative to buying shares outright.

You risk losing future profits in two ways as a put seller, so you need to be willing to assume these risks in exchange for the premium income:
  1. If the price of the underlying stock rises beyond the point value you received in premium, you lose the opportunity to realize profits by owning the stock. You settle for premium income only. However, when this occurs, your put expires worthless and you are free to sell another and receive additional premium.
  2. If the price of the underlying stock falls significantly, you are required to buy 100 shares at the striking price, which will be above current market value. It might take considerable time for the stock's market value to rebound to the striking price level. Meanwhile, your capital is tied up in stock you bought above current market value.

Selling puts as a means for buying stock (or exposing yourself to the possibility of buying) makes sense as long as you believe the striking price is a reasonable price for that stock. So if the put expires or falls in value, you profit from the short put. If it is exercised, you purchase stock at a price higher than current market value. This contingent purchase strategy makes sense because you can also recover the difference between striking price and market value by selling covered calls.

Example

From Put to Call: You sold a put on a stock that you would purchase at the striking price, based on today's values. That strike price was 30 and you received 2 ($200) for selling the put. However, after you sold the put, the stock's value fell to $26 per share and the put was exercised. You purchased 100 shares at $30 per share. Your net basis is $28 per share ($30 minus $2 you received for selling the put). You check options listings and discover that you can sell a covered call expiring in eight months for 3 ($300) and with a striking price of 27.50. If exercised, your overall profit will be $750 before calculating trading costs. The $300 received for selling the call reduces your basis to $25 per share. If the call is exercised at $27.50, you lose 2.5 points ($250), but you also gain $500 received for selling a put ($200) and a call ($300):
Purchase price of stock upon exercise of short put$3,000
Sale price of stock upon exercise of covered call-2,750
Net loss on stock$-250
Premium from sale of put200
Premium from sale of call300
Net profit$250
While the risks of put selling are far more limited than those associated with uncovered call selling, you can also miss opportunities for profits in the event of stock price movement in either direction.


Strategy 4: Writing a Covered Put on Short Stock

While covered puts are not the same as covered calls, there is a corresponding position. If you are short 100 shares of stock, you cover that position by selling one put. (Your put is also defined as covered as long as you have cash in your brokerage account adequate to purchase shares at the striking price).

In the case of a short put accompanied by a short position in stock, profit is limited to the net difference between striking price of the put and the original price per share in the short position. However, the potential loss is a far more serious problem. If the price of stock were to increase substantially, profits in the put would not be enough to match the resulting loss in the stock. Thus, the covered put does not provide the same definition of "cover" as does the covered call.

Alternative option strategies—such as buying calls—provide better protection for those with short stock positions. In the event the stock rises in value, in-the-money calls will match the loss with dollar-for-dollar profits. In comparison, the covered put is too limited to offer any true protection against the worst-case outcome.

Strategy 5: Creating a Tax Put

A fifth reason to sell puts is to create an advantage for tax purposes, which is known as a tax put. However, before employing this strategy, you should consult with your tax adviser to determine that you time the transaction properly and legally, and to ensure that the tax rules have not changed. (See Leveraging Your Leverage for more information on taxation of options.) You also need to be able to identify the risks and potential liabilities involved with the tax put.

An investor who has a paper loss position on stock has the right to sell and create a capital loss at any time, even if the timing is intended to reduce income tax liability. Such losses are limited to annual maximums. You can deduct capital losses only up to those maximums; the excess is carried over to future years. By selling puts at the same time that you take a tax loss, you offset part of that loss. The tax put is maximized when the put expiration occurs in the following tax year. (For example, expiration will occur in January or later, but you sell the put in December or earlier.) If your net stock loss is greater than the maximum allowed, the profit on the put is absorbed by that over-the-limit loss. By selling a put when you also sell stock at a loss, one of three possible outcomes will occur:
  1. The stock's market value rises and the option expires worthless. The stock loss is deducted in the year stock is sold, but profit on the short put is taxed in the following year, when it expires. This has the effect of enabling you to take stock losses in the current year but defer put premium gains until the following year.
  2. The stock's market value rises and you close the position in the put, profiting by the premium difference. This creates a short-term capital gain in the year the position is closed.
  3. The stock's market value falls below the striking price, and you are assigned the stock. In this case, your basis in the stock is discounted by the amount received for selling the put.

A potential problem arises in the event that the put is exercised within 30 days from the date you sold the shares of stock. Under the wash sale rule, you cannot claim a loss in stock if you repurchase the same stock within 30 days.

[caption id="attachment_12503" align="aligncenter" width="480"]Example of tax put. Example of tax put.[/caption]

The tax put provides you with a twofold advantage. First, you take a current-year loss on stock, reducing your overall tax liability, while deferring tax on the put sale until the following tax year. Second, you profit from selling the put, as shown in Figure above , in the following two ways:
  1. The premium income offsets the loss in stock.
  2. In the event of exercise, your basis in the stock is discounted by the put premium.

Put sellers enjoy an important advantage over call sellers: put risk is not unlimited because the stock's market value can only fall so far. An example of a put write is described next and illustrated with profit and loss zones in Figure below.

[caption id="attachment_12504" align="aligncenter" width="300"]Example of put write with profit and loss zones. Example of put write with
profit and loss zones.[/caption]


Example

A Strategy with Several Aspects: You bought stock at $38 per share, and it is currently valued at $34. You sell shares in December and take a $400 loss. At the same time, you sell a March 35 put at 6. The $400 loss in stock is offset by a $600 premium from selling the put. If exercised, adjusted basis in the stock is discounted by the put premium. The put is not taxed until exercised, closed, or expired, so this also creates a tax deferral on the option side and a current write-off for loss on the stock side. (If the buyer were to exercise the put within 30 days from the date you sold stock, you would not be able to claim the loss on stock, under the wash sale rule.)


Example

Finite Loss Potential: You sold one May 40 put at 3. The outcome of taking this short position will be profitable as long as the stock's market value remains at or above the striking price of $40. If, at expiration, the market value is below $40, the put will be exercised and you will buy 100 shares at $40 per share. Losses are limited between striking price and $37 due to the put premium received. If the stock's market value falls below $37, you will have a net loss at the point of exercise.

While the premium you receive for the put is yours to keep, you acquire stock above market value and you can then wait until the price rebounds. You could also absorb the paper loss on acquired stock by selling covered calls against it, further discounting your basis in the stock.

The most undesirable outcome you face as a put seller is that stock may become worthless. This is a remote possibility, but it remains within the realm of possible outcomes. You mitigate the risk by selecting stocks critically and applying fundamental tests aimed at identifying tangible value, rather than depending on popularity measures and technical indicators. The possibility only emphasizes the importance of selecting stock carefully before writing puts. In the event a stock became worthless, your put would be exercised and you would buy 100 shares at the striking price. Current market value would be zero. The more likely risk level is book value. It is always possible for a stock's market value to fall below book value. The fundamental value of a company's equity has little to do with market pricing, especially in the short term. Additionally, it is possible that reported book value has been inflated by reporting of exaggerated earnings, improper capitalizing of expenses, or underreporting of liabilities. All of these potential causes for loss have to be considered as possible risks when selling puts, not to mention as risks of purchasing stock even without involving options.

Tangible net worth—assuming it is an accurate value—often is overlooked in the more important factor affecting value. The perception of future investment value, which might be positive or negative, directly and immediately affects current share price. Even when the fundamental strength of a company has been established, the market might discount that value to some degree. Market pricing is far from rational, and you need to keep that reality in mind. Having this knowledge gives you an advantage, because you can judge a stock's value before deciding how or whether you employ calls or puts.

You need to be willing, as a put seller, to buy 100 shares at the short put's striking price, recognizing that exercise is possible when the put is in the money. In the event of exercise, the exercise price will always be above current market value. As long as you believe that striking price is reasonable, exercise is acceptable, because short-term price movement does not affect the stock's long-term growth potential. If you believe in the company's prospects as a long-term investment, selling puts can be a smart way to increase current income while discounting your basis in the stock.

The range of choices available in buying or selling options is vast, and anyone with a stock portfolio can employ options in numerous ways. However, it remains important to pick stocks based on smart analysis, and not on rumor or name recognition. One of the big pitfalls in trading options is to pick stocks based on option premium value, while overlooking the important fundamental and technical tests. Choosing Stocks: Finding the Right Ingredients provides you with guidelines for sensible stock selection.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

Posted in ...