Selling Put Options My Way

by Jerry Lee

  You will find that many of bigger-named stocks are on the January cycle. Therefore, the major earning months will be January, April, July, and October. There can be major market moves during these crucial months as the various earnings are reported. These reports can also immediately influence the options markets.

  Option Chain

  Option chains are a list of all available options for that particular stock. The option chain will show you many items in a format that usually follows the example below. In the example, you will see that even though it is condensed, there is plenty of information for you. As I sell mostly puts, I will give an example of a put chain of options. You will see that the information will usually be presented in a format somewhat like this:

  The month you have selected

  Strike price

  Symbol

  Bid

  Ask

  Last price at which the option was traded

  Volume traded this day

  Open interest

  Open Interest

  Open interest is the number of options traded at a designated strike price. Some lightly traded options might have an open interest of ten or less. Some strike prices will have an open interest in the thousands. Open interest is very important in my style of trading.

  TIP: I never use a stock that has less than 100 open interest at the strike price that I am going to use.

  The reason for this is liquidity. Suppose there are only ten options now listed for the open interest. If I open a position with ten more, I now control one-half of all the options traded at that strike price. Suppose I want to close my position, I now have to hope that if I put an in order to close the position, there will be someone who will want the other half of the trade. When you deal with a strike price with an open interest in the thousands, there is a ready market for all sides at all times.

  There is another way in which the amount of open Interest could affect the premium price. The smaller the number of open interest, the wider the spread between the bid and the ask price. An example of this would be an option that has a bid of ten cents and an ask price of twenty-five cents. If you were going to open a position and sell this put option, you would probably get the transaction done by selling the put for ten cents. If you immediately wanted to get out of this position, you would probably have to close the transaction by buying to close at the ”ask” of twenty-five cents, so you would immediately lose fifteen cents. When options have high numbers of open interest, usually the spread between the bid and the ask is only five or ten cents each.

  Intrinsic Value

  Intrinsic value is the value of the option if it were to expire immediately with the underlying stock at its current price. For a put to have intrinsic value, the current stock price must be below the chosen strike price.

  Example: The stock is now at $38 and the strike you are thinking about using is the 40 strike. The option would have an intrinsic value of 2. If the premium was 2.50, then it would have and intrinsic value of $2, with fifty cents of time value added.

  If the current stock price was at $44 and you had chosen the 40 strike, then your option price would have no intrinsic value and the premium would be made up of time value only.

  Time Value

  Time value, and using it to your advantage, is one of the most important parts of my style of investing! Time value does not mean a certain length of time but represents the amount by which an options total premium exceeds its intrinsic value. When doing my style of investing in puts, you will be only dealing with options that are completely made up of time value.

  Time Factor

  Options are a time-sensitive product. That means that since all options will expire on their expiration date, they are wasting away. To me, the time factor is one of the most important concepts to grasp regarding options. I will be teaching you to sell put options. What I want you to understand is that we will be selling puts that are completely out of the money and consist of all time value* and no intrinsic value*. We will just let the time value wither away. If all things are working in our favor, the premium will start falling in value and at a faster and faster rate as the expiration date gets nearer.

  *Note: Time value and intrinsic values are discussed in more depth in Chapter 7

  During the first week after opening a position, and assuming the stock does not make a dramatic move, the premium will stay near the same price at which the position was opened. However, as the fourth week starts to get closer, the premium begins to make a more dramatic move. That is the time factor eating away at the premium.

  An analogy might be a football game. Before the game starts, there is plenty of time for either side to make bets that will result in a win. However, as time withers away, only one side is going to be able to use the clock to their advantage. If one side is ahead by twenty-two points and there is only one minute left to play, it is obvious which team will probably win. Later, I will show you how I use the clock for each option move I make. The time factor refers to the number of days left in the options life.

  As I do not want to wait months for the premiums to wither away, 99% of my trades are for what is called the front-month or, in other words, the trading month we are now in. Remember that when dealing with options we are on a calendar that goes from the third Friday of the month to the third Friday of the next month. The options actually expire on Saturday, but Friday is the last day of trading.

  Trade Triggers

  Most brokerages will have a system where you can put in an order, which will be activated by a movement in price by either the option or the underlying stock.

  Example: My wife and I are going to the beach for a few days and we will be off-line. I have thirty puts on ZZZ stock at the 40 strike price. ZZZ is now at $46. I would probably put in a “trade trigger”, which might be placed to read as follows: if ZZZ stock drops in price to $44, buy to close my thirty puts of the May 40 puts at the market.

  This order will relieve the worry and concern that ZZZ might drop in price and cause havoc in my account. Most online brokerages will have a very simple way to enter the trade trigger. It will be an easy way to help protect your account.

  Placing Orders

  You will always have to be careful when entering any option order to make sure you get the order placed correctly. When placing an order regarding options, you will have four choices.

  Buy to open

  Buy to close

  Sell to open

  Sell to close

  In the above example where I set up my trade trigger, I had to make sure I used the term “buy to close.” If I had clicked on the “buy to open” by mistake, and ZZZ stock dropped to $44, I would have just acquired thirty puts.

  LEAPS: Long-term Equity Appreciation Position.

  Leaps are for the coming January, the next one after that, etc. If it is March 2nd and you want to sell a put for January of the next year or maybe two years out, those would be LEAPS.

  When I sell a LEAP put, it is not with the intention of keeping it for a long period of time but as a short-term play. I normally do not use many leaps in my trading style, as I do not like to lose control of the time factor. Sometimes I do use them as in the next example, but possibly only once or twice a year and then only in certain situations. When selling either LEAPS or front-month puts, the ideal situation is that the underlying stock price rises, and the sooner the better.

  Here is an example of where I used a LEAP put. (This trade will be discussed in more depth in Chapter 13.)

  On June 20, I sold a January put LEAP (long-term equity appreciation position) for Google, at the strike price of 220 for a premium of $7.68 after commission. GOOG was then trading around $290, On July 25; I closed the position at a cost of $3.80 (I bought back the same number of the puts that I had sold) for a net profit of $3.88 on each option. I had done sixty-five of these puts. This equals 6,500 shares of Google, and the profit was approximately $25,200 in thirty-five days. I did not invest a penny except for using some of m
y available margin.

  When I opened the trade, there were about 210 days to go until expiration date. This trade went for about thirty-five days. The point of that example is that not all trades will go until the expiration day.

  CHAPTER 5

  MARGIN and MAINTENANCE

  If you are not yet familiar with margin, you can think of it as a loan. Your brokerage has internal as well as federal guidelines regarding how much margin (loan) they can or will allow you. At times, you might hear margin also described as collateral or maintenance. Collateral can be cash, bonds, or stocks that are in your account. A very basic idea of margin works as follows.

  Stock Margin

  Say you have $100,000 in your account. Your brokerage might let you buy $200,000 worth of stock. You would then have $200,000 of stock value but you would also have a margin loan of $100,000. You will be charged interest for the money that you borrow while using your available margin. A general rule is that you can double your account buying ability for a stock that has full margin approval. However, your brokerage will have a value assigned for each stock, which is based on several factors. The volatility of that individual stock is one of the major factors and some stocks cannot be used for margin buying.

  Option Margin - Maintenance

  Option margin is calculated differently than stock margin. At times, you might hear option margin also described as maintenance. When selling puts, I might say you are using your margin. I also mean the residual amount of your maintenance. You will be required to have some account value to safely maintain each position. If your position changes in value, you will need more or less of your account value to maintain that position. Your account has a value, be it stocks, bonds, or cash. As you open positions, you are constantly using the remaining value of your maintenance until you have none left, resulting in a margin call. I will use the word “margin” in many places throughout this book, but remember that when dealing with options, many times it is interchangeable with “maintenance.”

  Again, each stock is assigned a value, which affects how much buying or selling you can do. The major difference in stock margin and option maintenance is that generally stocks use a two-to-one ratio of buying while using your margin. Again, when using margin to buy stocks, you are getting a loan from your broker and you will pay interest on the borrowed sum.

  Unlike margin funds used to buy stocks, you do not pay interest on your funds used for option maintenance. These maintenance funds are part of your account that is set aside so that the brokerage can maintain your account safely. This is for your protection and theirs. To figure your exact maintenance needed on each option, brokerages use a somewhat complicated equation.

  My brokerage and most others use one of the two formulas as follows, the one used is the one that requires the most maintenance:

  1. 25% of the current stock price, minus the amount that the option is out of the money, then add the amount of the premium you will receive.

  2. 10% of the strike price plus the premium received

  *with the strike price I usually use, it is nearly always the 10% ruled used to determine maintenance needed.

  Whichever of the two above is the largest will be the one used.

  Example: ZZZ stock is now trading at $54 you use the 40 strike price and receive a .50 premium.

  Using #1; 54 x 25% = 13.50, minus 14 (out of the money) = -.50, plus .50 (premium) = 0 each option

  Using #2; 40 x 10% + .50 = 4.50 each or $450per option.

  So in this case you would use the 10% method (#2 above)

  As each option represents 100 shares of the underlying stock the total is 450 of your account value is used to maintain each option position.

  If you used a stock such as Google that trades at $500 and you used a strike price of 400 and the premium for that strike was $2, lets do the math to see how much of your account would be set aside as maintenance.

  Using first method. 500 x 25% = 125., 125. minus 100 (out of the money amount) = 25, 25 + 2 (premium) = 27 for each share or 2700 for each option.

  Second method using 10% rule. 400 (strike) x 10% = 40 + 2 (premium) =42 per option or 4200 for each option. So again if you open this position using the 10% rule, 4200 will be set aside from your account balance. If you opened an account with $5,000. you could now only use $800 for trading.

  You must remember that the amount of maintenance required will change as the price of the underlying stock changes. This is called, “mark to market.” When selling puts, if the underlying stock price goes up, then less maintenance will be needed. If the underlying stock goes down in value, more maintenance might be needed. If you had used all of your available funds to open a position and the underlying stock dropped in price you would receive a “margin call.”

  Your brokerage will continually update your required maintenance. They will do this so that they can make sure, for your protection and theirs, that you have sufficient funds to close (buy back) the position if necessary.

  While trading, I try to use most of, but not the entire margin available. How much is available is continually posted on my account sheet. It does fluctuate throughout the day, and if you exceed your available margin, then you will get a margin call. There are several types of margin calls, and each one can be handled in different ways. Margin calls are the dreaded words of anyone who deals with stocks or options. If you do much trading, you will certainly get one of these eventually. If the email or phone call is not immediately addressed, your brokerage reserves the right to liquidate part, if not all, of your positions to bring your account within its guidelines. Each brokerage has its own, as well as Federal guidelines. Even though a margin call may seem like a real problem, it can usually be corrected by addressing a single position. I must admit that I use most of my available margin and consequently I get margin calls (maintenance required) often. Some brokerages will have a probationary type of situation where you are not allowed to trade or make other portfolio moves for a certain period of time after a margin call. Personally, I accept margin calls as a normal part of my trading.

  When you receive your margin call, you can address the problem by sending in cash for your account or transferring funds from other accounts. That is not the way I handle my margin calls. I choose to close positions and usually, if not always, I close the offending position. Assume that I have fifty put options on ZZZ stock. If I receive a margin call that says that I do not now have enough maintenance available for all of my positions, I then look at my current positions. If I am happy with my fifty puts, I might close just five of the puts instead of the complete fifty positions. This instantly frees up some of my funds so that my account is back in line to meet my brokerage requirements.

  If a complete position has turned against you and you have to close it, do not despair. By closing the offending position, it will free up some of your margin so that you can open a new position and possibly make up some, if not all, of your loss from the first trade. Keep in mind that if you opened a position for a $300 gain, and if the position turned against you and you then closed it at $600, you have a net loss of $300. If you can then find a position that allows you to make $300 or more, then you might come out even or possibly might even make some money.

  Regarding margin, one way that your brokerage is prepared to handle your lack of remaining margin requires you to remember that options sell for so little compared to the potential price of the underlying stock. For example, you may sell ten put options (1,000 shares) for ZZZ stock at a strike price of 40 and receive a premium of thirty cents each. When you do this trade, you would receive $300 (1,000 x .30 = $300). Entering this contract means that you are now obligated to buy, at any time during this option period, 1,000 shares of ZZZ stock at the price of $40. Let’s say you opened this position when ZZZ was at $46. If ZZZ drops to 42, the premium might now be sixty cents. You might get a margin call. Yes, your account is obligated for 1,000 x $40 = $40,000. However, you can still clear up the problem with 1,000 x .60, or $600
, by buying the options to close. This is a key component of options trading with puts and must be understood. You are obligated for $40,000, but $600 will buy you out of the situation. Of course, in reality you are not yet looking at having to buy the stock at $40 as the per-share price is still at $42. Again, remember that the person on the other side of your trade will not force you to buy his stock at $40 when he can still sell it for $42 on the open market.

  Margin, it is a very powerful tool and can certainly work both ways. It must be managed and monitored at all times. I think of my account as a business. You certainly would not start a business, call in every couple of weeks, and ask how things are going. Investors who buy mutual funds might have the luxury of checking their fund’s results on a monthly basis, but not option traders. To do options, you have to keep on top of what is happening in the market, and with your particular margin situation, you have to be proactive and involved. If you run your option account as a business, it can be very profitable. I check my account as often as I can and usually spend a half hour or more each morning to get the feel of how things are going in the market. I will check that none of the stocks that I am now using has had any major or unexpected news. I will make sure that my margin situation is under control and that I have some slack.