Options Education – Put-Writes
Stock market volatility has picked up in recent weeks, and the volatility has sparked some investor fear. Thus option volatilities have been going higher for the first time in many months.
As I’ve always said, think of option volatility in terms of insurance. If there are reports of a possible hurricane coming in the direction of your house, you would likely be willing to pay extra to have as much insurance as possible in case of mass destruction. However, once the threat of a hurricane has passed and your house is safe, you would have no interest in having extra insurance because of the added expense.
Similarly if Greece, China and Puerto Rico are all on the verge of “collapse,” traders would be willing to pay more for option volatility or put protection.
So how do we sell this elevated volatility/put protection? One way is to execute buy-writes/covered calls (we have several in our current portfolio). Another strategy is a Put-Write. (Note that some brokers will not allow “new” traders to execute Put-Writes. However, it may simply be a matter of asking for clearance to make such a trade.)
A Put-Write strategy, also called “naked puts” by some, is used when a rise in the price of the underlying asset is expected or, at least, a significant decline is not expected.
Traders often use this strategy when they’re willing to enter a long position in a stock but only at a price lower than the current price. (It’s popular among value investors, for instance.)
This strategy is the sale of a put at a specific strike price with the potential for loss until the stock hits zero. The maximum profit on this trade is the amount of premium received.
If I were to sell a put, and the stock went below my put’s strike price, I would be assigned 100 shares per put I’ve sold, thus making me long 100 shares per put sold.
For example, if stock XYZ is trading at 110 and I’m willing to buy the stock at 100, I could sell the XYZ 100 strike put for $1.
If the stock closes above 100 at expiration, I would collect a maximum profit of $1 per contract sold … or $100 per contract.
If the stock were to close at 99 at expiration, I would break even and be long the stock.
If the stock were to fall below 99, I would lose $100 per contract sold per point below 99.
As I said, this is a great strategy to collect yield in a stock that I would be willing to buy, and when put prices are elevated.
Take for instance Facebook (FB). With the stock trading at 88 today, I might be willing to buy FB for 80 a share. I could potentially sell the August 80 Puts for $1.00.
If FB closed above 80 on the August expiration, I will simply collect my $100 per put sold.
However, if FB were to close at 80 or below on the August expiration, I would be assigned on my put, making me long 100 shares per put sold.