Education about Selling Puts

[CoolChange]

I have seen a few posters here mention selling puts to generate additional return in a portfolio. While I understand the concepts at a high level, I am lost when it comes to the actual mechanics. Specifically, I am hoping for pointers to books, sites, etc. where I can educate myself on the following:

• Pricing and general mechanics of selling puts
• Strategy overviews / reviews
• Best house to utilize for this activity:
  
  - Something big/generalized like Fidelity, TD, Schwab, etc.
  - Somewhere more specialized like OptionsHouse​

I was prompted to start this thread by some others that resulted in a lot of good information about understanding, researching and including master limited partnerships (MLP's) and closed-end funds (CEF's) in a portfolio.

Thank you.

 

[gauss]

I went with Interactive Brokers some years ago based on the low cost of option trades. They are <= $1.00 per contract (option on 100 shares). They do have a $10 minimum per month commission however.

Mechanics are similar to any online brokerage account. See the bid and ask prices on the various contracts at any given time. Select sell to go short.

Beware that selling uncovered puts exposes you to unlimited downside liability on your part. Your brokerage will probably close out your positions if you don't maintain enough capital with them to cover all your positions at all times. Your legal liability however will exceed this capital amount and they can come after you and your other collectible assets for the balance.

-gauss

 

[utrecht]

The commissions on options at a place like Schwab or Fidelity will kill you. If you are serious you need to use OptionsHouse or another specialty broker. Not sure why you are shying away from them. I can buy anything at OptionsHouse that you can buy at Fidelity (plus futures contracts, bonds currency ect) but I can do it cheaper, quicker and more efficiently. Stock commissions are $3.95

I do a lot of options trading and day trade stocks as well. Feel free to ask whatever specific question you want. Here or in private.

 

[Senator]

A few notes about selling puts, or calls.

When you sell, and receive a premium, you are OBLIGATED to perform. When you buy a put or call, you have the OPTION to perform.

Selling puts is a great strategy, especially if you want to buy a stock anyway. If you sell a put, without any risk management strategy, you will be forced to buy the stock at the price you already promised.

If the stock goes up, the stock owner generally sells in the market, and you have the premium to keep. If the stock goes down, the stock owner generally sells to you, and you have to purchase the stock at the price you promised, regardless of the market price.

They can be a great strategy, you are providing insurance to the buyers of the puts (you are the seller). You get the time premium, plus the risk premium. Most options expire worthless, and that is what you generally want when you sell a put.

 

[jim584672]

Beware that selling uncovered puts exposes you to unlimited downside liability on your part.
-gauss

Not to be a nit picker, but selling a naked call has potentially unlimited liability since a stock could go to infinity. A naked put is limited since the stock could potentially go to zero which is the limit of loss.

 

[utrecht]

Most puts sellers don't get the stock put to them if the price drops below their strike. Most people just buy the puts back at a loss. So based on that theory, you are not obligated to do anything just because you sell puts.

 

[jim584672]

Potentially the option COULD be exercised at any time (American style options) but usually aren't. In the money options WILL be exercised on expiration date.

 

[utrecht]

Even if the options are exercised, you can still just immediately sell the stock so the end results is basically the same thing. Your position is closed at a loss and you move on to the next trade.

 

[ownyourfuture]

I understand you mentioned selling puts.
This is sort of the opposite. But I thought you might be interested.

Since September 2011, I've occasionally sold covered calls on stocks I own when they become overbought. My account is @ Fidelity
This can generate additional return in a portfolio, just like selling puts.

The Basics Of Covered Calls

My latest was American Water Works AWK
This is one of my core holdings.
On Monday, August 17, I looked at the chart and decided it was over-bought and figured the uptrend was unsustainable.

I use a simple three-month candlestick chart with Bollinger bands, 50 day moving average, and MACD

AWK - SharpCharts Workbench - StockCharts.com

Before I go any further, let it be known that I am not an expert at technical analysis.

I sold 3 September $55.00 calls. The premium was $.90 per-share.
300 x .90 = $270.00 Minus $10.34 Commission/Fees Net = $259.66

Obviously, they don't always work out as well as this one has to this point.

In the almost 4 years I've been doing this, I've managed to make an additional $7,000 in income.

This would be much higher, if I hadn't lost my behind selling covered calls on Eli Lilly a couple times.

Because the stock continued going higher after I sold the covered calls, and I wanted to keep the stock, I was forced to buy back the contracts at a much, much higher premium.

That was the first and most important lesson I learned when it comes to selling covered calls. Since Eli Lily is a drug company, the stock can easily go up 7% to 10% in a single day on news of a new drug in the pipeline, a drug receiving FDA approval, etc

So now I stick to selling calls on more boring stocks. Sure the premium isn't going to be as high as more volatile stocks, but it's still additional income and I love doing it.

I also on occasion, use the candlestick charts to add to holdings, when I think their oversold.

Good Luck

 

[Onward]

Selling naked puts is a very risky endeavor.

I know 'cause I been there.

It's one of the things that made me a boring old index investor.

 

[NW-Bound]

... Because the stock continued going higher after I sold the covered calls, and I wanted to keep the stock, I was forced to buy back the contracts at a much, much higher premium.
...
So now I stick to selling calls on more boring stocks. Sure the premium isn't going to be as high as more volatile stocks, but it's still additional income and I love doing it...

I do covered calls from time to time. And I found myself often either buying them back at a higher price (hate to do that), or giving up my good stocks, and keeping the lousy ones.

The boring stocks often do not give enough premiums to make it worthwhile.

I do this as a pastime, and suspect that my good and bad moves all cancel each other out.

 

[ownyourfuture]

ATTN NW-Bound

"The boring stocks often do not give enough premiums to make it worthwhile"

This is true, but if you look at the chart of AWK I included, you can see it was acting like a growth stock at the time, not a commodity stock.
http://stockcharts.com/h-sc/ui?s=AWK&p=D&b=5&g=5&id=p21814435483
The premium, combined with the short duration of the option, made it worthwhile.
** Of course there's still 22 days left before the option expires, plenty of time for it to go against me**


"I do this as a pastime, and suspect that my good and bad moves all cancel each other out"

That's why immediately after I started selling covered calls, I made a spreadsheet specifically for only those. This includes a running +/- total

 

[utrecht]

Covered calls and selling naked puts have the same profit profile. The problem with covered calls for a trader is needing to tie up huge amounts of capital to buy the stocks so you can sell the calls. When selling naked puts, you can use collateral from the rest of your portfolio to sell the puts. You dont tie up any money at all.

Now, if you already own stocks for the long term and want to sell calls for additional premium thats a different story.

 

[TallTim]

To the OP's question:

Specifically, I am hoping for pointers to books, sites, etc. where I can educate myself on the following:

• Pricing and general mechanics of selling puts
• Strategy overviews / reviews
• Best house to utilize for this activity:
  
  - Something big/generalized like Fidelity, TD, Schwab, etc.
  - Somewhere more specialized like OptionsHouse​

Like others, +2 to using a real platform if you want to trade options in a cost-efficient way. Interactive Broker is good, so is LiveVol. TD Ameritrade has a nice interface called ThinkorSwim. All are good in terms of letting you see the information you need in order to trade in an organized way and act quickly on that information. NB: this is not an exhaustive list, just those with which I've personal experience as a user and feel I can comment intelligently.

In terms of education, any of the large brokerages will have a lot of free materials, etc on their sites, esp if you have $$ with them. The more you have (and the more you trade) the better your commission structure will generally be; commissions are relatively small, depending on what you're used to -- but if paying something like $10-12 per trade (commission, SEC fees, etc) is off-putting, then maybe options aren't a good fit.

Selling cash secured Puts can be OK stand alone or a part of a larger plan, but very wise to educate yourself on how options work and are priced BEFORE you start trading in your acct. Also, note that your account will need to be approved for options trading before you can do these kinds of trades, as they do have the potential for large losses/costs (buying stock at a set price that can be well above the trading price at the time of option expiration)

Many of the large brokerages will allow you to do so-called paper trading in your acct first and this is a good idea; you can test strategies and trades and see how things move around and decide if you're comfortable with a given strategy, risk allocation or underlying to trade.

Having said all that, and noting that NONE of this is investment advice ...
IMHO, selling Puts is a good income strategy, if you are disciplined and follow some simple rules, e.g.:

- Don't sell P in a name that you wouldn't be happy to own at the price. For example, AAPL at $90 might look like a better buy than say Yahoo at $47 or Exxon at $90.

- Don't sell more puts than you have cash (or other equities' value) to pay for in case the stock comes to you; and you should be OK with the stock coming to you at that price (See first bullet). Note, if you're trading in an IRA, Roth or other tax-advantaged account most brokerages will force you to do this anyway.

- Have an exit plan at the beginning of your trade (for example, if you sell Ps for $100 you want to be OK to buy them back for some price $10, $15, $5, $1 .. to take your profits and close the position) and be OK with making an OK but not outrageous profit (pigs get fat, hogs get slaughtered)

- Have a limit of loss for a bad trade and get out once you hit that limit; similarly, have a total portfolio max % to use for these kinds of trades (e.g. for beginners maybe 5-10% max) -- and stick to these rules!

- Be willing to put in the time to learn about options and how they work .. and also to watch the market and your positions. For example, if you trade monthly options, you'll need to pay attention closely the 5-10 trading days before expiration (generally, the third Friday of each month) and also over the trailing week or weekend to reload your positions. If you decide to trade weekly options, it will require more time and diligence in exchange for higher profit (and risk level).

Mostly, it's about education and risk management ... and it can be lucrative. IMO, it's also fun and keeps me mentally engaged in a fast-paced activity that DW doesn't particularly care about

 

[CoolChange]

Many thanks to those who have already responded to this inquiry. This has already been useful to me and hopefully will be to others as well.

To give you a bit more information about where my head is on this: I am currently significantly overweight cash for a variety of reasons.

• A devout indexer/asset-allocation disciple would just dump all of this cash into the market today (actually, many days ago when my allocation got so out of whack).
• I am not so devout, not necessarily believing the market is 100% efficient, especially in the short term.
• Currently, I am placing some buy limit orders; but, many of them will likely never execute.

My rather simplistic questions:

• In this situation, wouldn't I be better off selling puts and getting paid to wait?
• For those of you who do sell puts (especially on widely held ETF's), how do you decide on appropriate pricing?

This may very well be a bad idea for me to pursue at this time since I am currently unable to regularly devote much time to monitoring the markets.

Thank you again.

 

[utrecht]

If you already have a limit order in to buy a stock then, yes, selling puts is a good idea. Lets say you have a limit order to buy Apple at 100 because you think its a good value at that price. Selling a Sept 100 put is a good strategy. You could collect .92 right now for that put. The downside is that if Apple drops to 98 next week but is back to 103 on Sept expiration, you wont own the stock. You will keep the $0.92 (which is really $92 per contract) though.

If Apple is below $100 on Sept 18, you will have the stock put to you at $100 but your actual cost basis will be $99.18 (minus commissions).

I dont sell puts for this purpose though. I sell naked puts as a trading strategy.

 

[utrecht]

To the OP's question:



Like others, +2 to using a real platform if you want to trade options in a cost-efficient way. Interactive Broker is good, so is LiveVol. TD Ameritrade has a nice interface called ThinkorSwim. All are good in terms of letting you see the information you need in order to trade in an organized way and act quickly on that information. NB: this is not an exhaustive list, just those with which I've personal experience as a user and feel I can comment intelligently.

In terms of education, any of the large brokerages will have a lot of free materials, etc on their sites, esp if you have $$ with them. The more you have (and the more you trade) the better your commission structure will generally be; commissions are relatively small, depending on what you're used to -- but if paying something like $10-12 per trade (commission, SEC fees, etc) is off-putting, then maybe options aren't a good fit.

Selling cash secured Puts can be OK stand alone or a part of a larger plan, but very wise to educate yourself on how options work and are priced BEFORE you start trading in your acct. Also, note that your account will need to be approved for options trading before you can do these kinds of trades, as they do have the potential for large losses/costs (buying stock at a set price that can be well above the trading price at the time of option expiration)

Many of the large brokerages will allow you to do so-called paper trading in your acct first and this is a good idea; you can test strategies and trades and see how things move around and decide if you're comfortable with a given strategy, risk allocation or underlying to trade.

Having said all that, and noting that NONE of this is investment advice ...
IMHO, selling Puts is a good income strategy, if you are disciplined and follow some simple rules, e.g.:

- Don't sell P in a name that you wouldn't be happy to own at the price. For example, AAPL at $90 might look like a better buy than say Yahoo at $47 or Exxon at $90.

- Don't sell more puts than you have cash (or other equities' value) to pay for in case the stock comes to you; and you should be OK with the stock coming to you at that price (See first bullet). Note, if you're trading in an IRA, Roth or other tax-advantaged account most brokerages will force you to do this anyway.

- Have an exit plan at the beginning of your trade (for example, if you sell Ps for $100 you want to be OK to buy them back for some price $10, $15, $5, $1 .. to take your profits and close the position) and be OK with making an OK but not outrageous profit (pigs get fat, hogs get slaughtered)

- Have a limit of loss for a bad trade and get out once you hit that limit; similarly, have a total portfolio max % to use for these kinds of trades (e.g. for beginners maybe 5-10% max) -- and stick to these rules!

- Be willing to put in the time to learn about options and how they work .. and also to watch the market and your positions. For example, if you trade monthly options, you'll need to pay attention closely the 5-10 trading days before expiration (generally, the third Friday of each month) and also over the trailing week or weekend to reload your positions. If you decide to trade weekly options, it will require more time and diligence in exchange for higher profit (and risk level).

Mostly, it's about education and risk management ... and it can be lucrative. IMO, it's also fun and keeps me mentally engaged in a fast-paced activity that DW doesn't particularly care about

Very nice post except for the sentence that I bolded. I sell puts all the time and never want to own the stock. Its a trading strategy. If I'm wrong and the stock drops below my strike, I buy the puts back at a loss and move on.

 

[CaliforniaMan]

It all sounds a bit too much like w*ork to me. Think I will stick to my lazy buy and hold index funds.

 

[TallTim]

Very nice post except for the sentence that I bolded. I sell puts all the time and never want to own the stock. Its a trading strategy. If I'm wrong and the stock drops below my strike, I buy the puts back at a loss and move on.

@ utrecht, thanks and I agree w you both in terms of strategy and what I would do as experienced trader, but in giving info to the OP who is just starting out, I would say start with things you would be OK to own.

 

[NW-Bound]

I sell puts all the time and never want to own the stock. Its a trading strategy. If I'm wrong and the stock drops below my strike, I buy the puts back at a loss and move on.

Selling put is basically betting that the market will not fall. It works well in a bull market like the last 5 years.

It all sounds a bit too much like w*ork to me. Think I will stick to my lazy buy and hold index funds.

Yes, it takes some work, but can be fun if you are so inclined. The most important thing is to be sure that this hobby makes you money, and does not cost too much. As I said, it is hard to do the accounting, not simply in terms of money made but also in opportunity costs by comparison with other forms of investment.

 

[TallTim]

@ utrecht, thanks and I agree w you both in terms of strategy and what I would do as experienced trader, but in giving info to the OP who is just starting out, I would say start with things you would be OK to own.

A fair point ... but it's fun for those who do it and unless you get to a very advanced level, you can do well in options for a few days' time per month -- particularly here on the west coast where you can be 'done' when the market closes at 1 pm PDT.

That said, my FIL trades nearly full time, though he's 75 and retired. IMO, he likes the activity and it appeals to his logical, techy math brain. I don't do quite as much, but we still have teens at home. YMMV, but I've been able to more or less exceed my gross annual expenses in gross trading receipts the past 5-7 years on probably 10-20 hours a week. It beats working at WMT!

I'd be FI w/o the trading income, but it provides a nice RE expense cushion on the upside for fun diversions

 

[clifp]

At Utrecht suggestion I opened an account with OptionsHouse a couple of years. Their commission were lower than Schwab $5 for 5 options,but they've raised their price now $5+.50/contract (for new customers) that I don't really use them very much anymore.

I find their trading platform to be vastly inferior to Schwab's StreetSmart Edge and their end of year reports pretty hard to integrate with Turbotax. So for the $7-$10 /trade I save in commission for roughly 3 options I write a month most of which are in IRA. It just isn't worth the hassle.

Interactive Brokerage rates appear to be the cheapest out there, so if you end up trading options a lot than look at opening an account with them. However, assuming you have an account on Schwab, Fidelity or TD starting with them is just fine.

On the forum there really 3 schools of thought on option trading.
A. No Options. Options are too risky, too hard; no thanks: the majority.
B. Mostly stocks investors, but we will write calls or puts to generate income or getting paid to wait. Plus its fun. This includes myself, NW, Senator and fair number of other long time forum members.
C. Active option traders. Trading options (primarily writing) is a significant source of income.Utrecht is the main person who does this. A couple of years he posted a pretty comprehensive breakdown of his option trades. I was able to mostly replicate his success, but ultimately I decide that modest gains weren't worth the time and hassle.

Finally there is 4th group, which isn't seen very much at all on the forum and that is the speculators. The think they can become rich quickly. By spending $500 to buy 5 Apple 100 puts,they can easily turn that into $10,000 when Apple collapses to $80. These people are mostly young and male and are convinced they are gifted traders. This was me when I was in my early 20s. My belief is that since so many folks on Wall St. fit this profile that options are systemically over priced.So even though options are zero sum game I think they are slightly more profitable to write than buy. Note data on this is hard to come by and far from definitive.

What is true is a retiree survival rates are enhanced if writing covered calls transforms a 2 year stock sequence of +35%, -15% into +30%, -10%. Reducing volatility is good for retirees.

My rather simplistic questions:
In this situation, wouldn't I be better off selling puts and getting paid to wait?
For those of you who do sell puts (especially on widely held ETF's), how do you decide on appropriate pricing?

.

I write two kinds of puts, on individual issues that I am happy to own at a specific price. So this week I wrote Jan. 2016 puts Apple @90, Exxon at 60, and Procter Gamble at 65. Regardless of the state of the market, I think those are fair prices. In the case of PG and XOM the dividend yield at those prices is higher than my 4% HELCO that I might need to temporarily use to buy them. I try to make sure I'm getting a 10% annualize return but I am more concerned with picking a price which to me is an bargain.

In the case of ETFs like SPY. I require a minimum of 15% annualized return for at the money options and 10% for out of the money options.
The annualized return is calculated by Premium/(Strike Price- Premium) X 365/(number of days remaining for the option.)

So today with the SPY at 199.27 I can sell at Oct 16 Put at 199 strike price for about $6.25. There are 51 remaining days on the option. This works out to be 23.2% on an annualized basis. Now remember this a cap on your return, and if the S&P finished below 193 you lose money. But for most of the year the returns were far lower because the VIX (volatility index) was between 10 and 15. It shot up to 40 on Monday and still is at 26. Which is well above average.

 

[NW-Bound]

What is true is a retiree survival rates are enhanced if writing covered calls transforms a 2 year stock sequence of +35%, -15% into +30%, -10%.

Reducing volatility is good for retirees.

I did not think of this side effect.

In the past, when my stocks got called by covered calls, I was upset to lose the stock and leave money on the table. I forgot that when I wrote the call, I did not believe the stock was going to be worth that much. "Losing" the stocks actually forced me to "sell high". The problem was I often forgot that it could have meant that the market was frothy, and I should not plow that money back into the market or into that same stock.

I believe in "Tactical AA", meaning lowering stock AA when the market is high, and raising stock AA after a market crash. The above would jibe with that philosophy.

 

[TallTim]

@cliffp

Good insight and agree w your assessment of the types here. IMO I would fit into 3, but started as type 2. Type 4 either make so much $$ (our anon $100mm windfall guy from a few months back comes to mind) that they buy an island and a plane and disappear or they lose tons and work forever -- in neither case would they post here.

I like your recent trades and have put similar ones on this week as well. Given the high volatility several strong dividend payers were real bargains in terms of yield.

To the OP Q about why Puts vs Calls, yes you can make $$ buying calls as well but it ties up a lot more capital. Plus, Puts are always priced slightly higher from a seller perspective b/c of the options pricing models -- so more return for a given level of risk and investment from Puts vs Calls in a normal environment.

As for price selection on an index or ETF option, cliff has summarized it well with his example. All of the trading platforms also have fairly powerful screening tools that allow you to search option positions by various criteria including annualized return, ROCE, probability of the expiring 'in the money' and many others. You can apply the screen to a ticker symbol and see what it provides or bounce a set of criteria against a whole index of stocks (S&P say or Russell) or all ETFs or futures and it will spit out a list of trades you can then consider and evaluate.

Finally, and w/o getting too technical here there are a number of measures (so-called Greeks) that you can use just looking at an option chain screen to pick an option position that meets return or risk criteria you have already set.

Hope all this helps. Again, as I said before its worth paper trading a bit or starting with small lots, especially in index funds or futures as the dollars (/ES, VIX, SPX, RUT, or NDX) can be higher



Sent from my iPhone using Early Retirement Forum

 

[gauss]

Not to be a nit picker, but selling a naked call has potentially unlimited liability since a stock could go to infinity. A naked put is limited since the stock could potentially go to zero which is the limit of loss.

Excellent point. Thanks for the correction. It has been a while since I have traded options....

-gauss