Selling Put Options My Way

by Jerry Lee

  The third week starts great, and ZZZ rises back to $51. Immediately the option premium falls to .05. For the rest of the cycle, the stock stays around the $51 price and the premium stays at .05. You could, of course, buy the option to close at any time for the remainder of the trading cycle for .05, or approximately $50 cost. This would equal a net profit of $200. Or you can just let it expire after the last Friday of the trading cycle.

  In making this trade, you used ten puts, which is equal to 1,000 shares of ZZZ stock.

  If the position is left to expire, (.25 x 1000 = $250 net profit).

  Second Scenario

  In the first week, ZZZ stock starts off on Monday morning by dropping by seventy five cents and immediately the option premium rises to .35. Hmmm, this is not good, but neither the stock price nor the option premium have reached the point yet where you draw the line and close the position. For the duration of this first week, ZZZ bounces around the $49 to $49.50 price. The premium is still thirty-five cents.

  During the second week, the stock price bounces around the 49 point all week long. By the end of the week, the premium falls to twenty-five cents. However, after the third week, the stock has dropped to $47 and the premium now has also fallen to twenty cents.

  This demonstrates the effect that the loss of time has on a premium. As you can see, with one week left, the stock price is falling, but not fast enough to reach the strike price at this rate. The other side of the trade is now starting to see the light and they want out while they can still salvage some of their original premium.

  The last week of trading and ZZZ opens Monday and stays around the $47 price and immediately, the premium drops to ten cents. By Wednesday, the premium drops to five cents and stays there until the close of trading on Friday. Therefore, even though the stock dropped $3 during the trading cycle, the time factor ate up the premium.

  Third Scenario

  In the first week, ZZZ starts the trading cycle staying around the $50 price range but on Wednesday, a stock in the same type of business reports their earnings, and the report is not good. All stocks in the same type of business drop on the news. When checking your positions on Wednesday night, you see the news. You wait to see what happens on Thursday, and on Thursday morning, ZZZ drops to $46 and the premium rises to forty-five cents. Wow, this is not good! You have two choices—either close the position and take a loss or wait for better news

  Factors to Weigh for a Declining Position.

  Pros of keeping the declining position open:

  ZZZ still has good reports.

  ZZZ does not compete in exactly the same business.

  There is still $6.00 before the stock reaches the 40 strike and the premium has not yet doubled.

  Cons of keeping the declining position open:

  There are still 3 ½ weeks until expiration (lots of time for more bad news.)

  All stocks in the same business get a downgrade from a major brokerage.

  You are nearly at the premium of fifty cents, which would tell you close the position.

  So what would you do?

  For me, this would be a situation where I would immediately close the position. I do like the 6 of stock cushion remaining, but with this much time left for more bad news, I will take my loss and move on to better stocks. The danger of turning on the computer on Friday morning and seeing the premium at .90 or higher is just too big. It was a good play that did not work out. They will not all follow a script. Move on and always remember that the rule of closing a position at the point of a doubled premium is the final line. There is nothing wrong with saying, “Wait a minute, I do not like the way things are going.” You can always close a position at any point during the month. In addition, another way to look at this situation is to objectively say, “Would I now open this position?” If the answer is ‘Heck No’ then that is a good clue that it is time to close the position.

  Gap Up or Down

  When a stock receives very bad or very good news before the stock market opens, it can cause what is called a gap movement. The stock might have closed on Monday night at $50, but before the Tuesday opening, the company reports that the FDA denied a drug application. The stock starts trading on Tuesday morning for $44, which would be a $6 downward gap move.

  The corresponding movement in options might be just as dramatic. The option was at .35 on the day before the bad news. As the stock gaps down, the put option premium will gap up. Therefore, when the market starts trading options, your previous thirty-five-cent option might now be $2.50. If this happens, then you must face the situation and take your loss. This is another reason you try to avoid a stock with so much resting on one product. Try to be diligent with your research. This same thing can happen to a stock during an earnings month when it reports bad news, which is why I try to avoid stocks with any potential ”big“ news. If you insist on using one of these stocks, always leave plenty of cushion.

  CHAPTER 16

  BID AND ASK

  When you go to the option chain list, you will see a bid and an ask premium for each option available. The difference between the two prices is called the spread. I have fought the spread many times and won very few of those battles. When selling a put, I have often entered the order at the ask (the higher of the two). Very few times will that order go through. If you put in this order and it does go through, there is a good chance the stock price has dropped some and the premium is rising. So now the previous ask is now the bid, and there is an even higher new ask. Discussed earlier was the theory that if you are not overly anxious to open the position, then you might try the ask price. Sometimes, if the bid and ask price are separated by ten cents or more, you can get a trade through by making an offer between the two prices. However, for a general rule, take the bid (lower) and get the position open. This is another reason that, when figuring my potential returns, I use the bid price.

  The opposite is true when closing a position. Since you are now buying the put to close, you, of course, want the lower price. Good luck! If you want the position immediately closed, then take the ask price. There is an unwritten rule that says you, the trader, will always get the worst of the two premiums. If you are buying, you pay the highest (asked) and if selling, you get the lowest price (bid).

  During a trading period, say the bid and ask have retreated to .05 bid and .10 ask. This nearly always means that there is very little time left in this period or that a lot of cushion is remaining. Do not forget that even though you are almost sure you have a winning position, you are still tying up maintenance funds that might be better used elsewhere. In these cases, I usually put in a “buy to close” order for .05. If the trade goes through, then I am able to re-use the maintenance funds on a new position that pays more.

  Again, usually, when closing a position—unless there are only a very few days left, you will not get the bid. To close the position, you will normally have to take the .10 ask price. If you have a lot of cushion and not much time left, sometimes there might be no bid and only a .05 ask. That means there are no offers, so you would be the only one offering anything for that option, and you would then get the .05.

  Again, the rule of thumb is that whether you are selling or buying, as a trader, you will get the worse of the two prices out there.

  A Premium That Is Just “Too Good”

  Often you will find an option premium that looks just too good. As a general rule, when a premium gets over the 6% return (premium divided by the maintenance needed), this should make you question your stock selection a little deeper. I start thinking, “Hmmm, I must consider that I might have missed something when using my filters.” If it is a pharmaceutical stock, I will usually find that they have a review by the FDA or some type of review of a product, etc. Pharmaceutical stocks scare me. I do use them, but I handle them carefully. Keep in mind if the strike price you have chose offers a premium that is “too good”, you should use the next lower strike price. This gives you more cushion and will usually still provide a decent r
eturn.

  Another thing to check for, if premiums are a little high, is that possibly the underlying stock will have a dividend payout due during this period. Usually the stock will drop some on payout day to reflect the dividend. When Microsoft paid out a $3 dividend, the stock dropped three points. Otherwise, people would buy the stock before the dividend is paid, collect the dividend, and then sell the stock. When you sell a put, you will not receive a dividend on the stock if one is issued while you have your “sold put” position.

  A while back, the company with a stock sign of RIMM (the maker of the Blackberry device) was going through a patent lawsuit. Every day brought a different development. The court day was postponed, or rumors of a settlement were whispered. The stock would fluctuate by several dollars as the rumors circulated. This kind of situation can play havoc with options positions. Thorough research before investing should have alerted you to this type of situation and saved you some worry.

  A situation like the one with RIMM can offer high rewards if you guess correctly. Getting back to why 90% of options traders lose money, it is because they use flyers, guesses, and even prayers on this kind of play.

  A personal problem I have while trading is my lack of patience. I am always fighting the urge to tweak my plays and move into a better trade. Certainly, there is a time for rolling up or closing one and opening another. However, if you suffer from the same affliction, make sure your move is based on solid thinking rather than just itchy feet. During the last four years, I have learned to recognize that feeling of “there just has to be a better trade out there.” I can now control the urge, but it is lurking out there, always trying to get its way.

  My investing goal for the last few years is to attain a steady income growth. I do not need the worry of one missed “guess” to wipe out several months of hard work. Nearly everyone to whom I have taught this method of investing has gone through a similar first stage of amazement and then a lack of common sense. A person does a few trades and magically, money appears in their account. Before long, nearly all have started making poor choices.

  I hope the cautions that I have tried to express to you will help you avoid this stage of put selling.

  CHAPTER 17

  TAKING PROFITS

  Very often, you will come up with situations where you wonder, “Should I take a profit or leave the position alone.” You are never wrong to take profits. There have been trades where I have made just pennies, but at least I was a winner. Conversely, you are never wrong to take a loss rather than letting losses build. If you are ever in doubt, and believe me there will be many of these times, a general rule that has withstood the test of time is to let your profits run and stop your losses. I have tweaked this somewhat, but the basis is still true. You also must learn how to trade a position that is starting to worry you. For me, if I am in doubt as to whether to keep a position open or to close it because it is starting to worry me, I close it. It is that simple!

  Quite often, the underlying stock turns around and does as I had hoped it would in the very beginning. However, after closing the position, the worry was gone and I can move on to a trade that is responding correctly. There are plenty of trades out there. If you are starting to worry, it is time to close the position and find a good trade. By worry, I do not want you to mistake “concern” with the feeling of “Uh-oh, this position is going south quickly, what should I do?” When you get those uh-oh feelings, that is the time to close the position and move on to a trade that is less stressful.

  It is human nature not to want to fail. You will be tempted to try a make a winning position out of an obvious bad situation. However, if your common sense is saying, “Hey, something is wrong here,” be aware that the other side of your brain might try to convince you to just give it a little more time. After all, you are very smart and you make such few mistakes. You will argue with yourself quite persuasively.

  Examples of arguments you will use to maintain a poor position:

  The stock is about to split and cannot go down any more.

  Oh, really, why not?

  There is plenty of time for good news.

  And plenty of time for more bad news!

  It has already dropped so much; it has to turn around.

  Why should it?

  Etc. etc.

  Over the years, I have fought this battle many, many times. I now usually recognize the symptoms and close the position. Often, time proves that I was hasty in my choice to close the position. However, the sense of relief after the decision is made is well worth being hasty. Dealing in options will give you quick feedback, and you can torture yourself with “woulda-coulda-shouldas.”

  The market does what the market does. It does not need to be fair or sympathetic. Whenever you lose money because the underlying stock did something that you thought was really odd, remember that somewhere there is a trader saying, “Alright, it did just as I thought it would.”

  To be objective, get familiar with the safety rules and follow them. Do not let your ego and your desire to make each position profitable interfere with your better judgment.

  Remember this, if nothing else.

  There are plenty of good and profitable positions out there. Do not stick with a losing situation.

  People who lose money will consistently let a losing position run too long. Remember, you might want to let your profits run, but always cut your losses.

  CHAPTER 18

  NAKED CALLS (uncovered calls)

  If you find yourself in a bear market, you may find that it is just not safe selling puts, then do not sell puts! A bear market is a great time to give some serious thought to selling naked calls. In many ways, it is safer than nearly any other type of option trading. The “experts” might say that your losses are unlimited, as you could sell a naked call at the 30 strike and the stock goes past 30, and it will be unlimited how high the stock can go. Well, putting in a buy order for the underlying stock will help to alleviate that fear.

  Selling a naked call is a lot like naked puts except that you sell an uncovered call. This means that you do not own the underlying stock. You have entered a contract to furnish the stock to someone if he wants it for the chosen strike price.

  The best scenario for this play is to use a stock that is trending down.

  Example: ZZZ Company is now at $40 and ZZZ and its peer group are not performing well. In fact, they never do well during the summer months. You look at the option chain and with the stock at $40, the 45 call strike price is selling for thirty-five cents. You go through your filters and find that analysts have downgraded the stock to a hold or a sell. Looking through the chart history of ZZZ, you see that it never does very well in August.

  This looks like a great candidate for a naked call, which means that I can sell a call at the 45 strike price for a stock that I do not own. The potential problem should be obvious: I do not have the stock to furnish the other trader if the stock does move up to, or above, $45.

  When I do naked calls, I always put in a standing order to buy the stock, “at the market” if the current stock price gets within twenty-five cents of the strike price I am using. If the stock does moves up and reaches my 44.75 (in this example) trigger point, the stock will be bought for my account. This will then turn the naked call into a covered call. If you leave yourself hanging out there without the protection of a buy order for your stock, you are asking for trouble. However, if the stock goes past your buy point and your order is filled and the stock continues rising, you will be called away, and make roughly .25 on top of the original .35 with the naked call.

  Sell option for thirty-five cents

  Have to buy stock at $44.75

  Stock called away at $45. Make twenty-five cents

  This equals a potential sixty-cent profit.

  Of course, the stock might pass through the 44.75 point; if so, your buy order is activated. You now own the stock, and then the stock might fall back in price. That situation can happen, but if the stock runs f
rom 40 to 44.75 within a few weeks, then the news regarding the stock must be good. Owning this stock and then selling covered calls for the next month is probably the best answer. If the stock is still around the 44.75 point after expiration day, you then have two choices. You can sell a covered call option for the next month, or just sell the stock on the following Monday since you would not have been called away.

  When doing naked calls, you must have the available margin to cover the buy order that you put in. This means that you cannot make the same returns with this style of trading as with naked puts. If you had sold 10 calls of the 45 call strike price, your potential cost of buying that stock would be approximately 50% of the strike price, times the number of options. (45 divided by 2 x 1000 = $22,500.) Therefore, to have sold this naked call you would have had to have approximately 22,500 unencumbered funds sitting in your account. To have sold that many naked puts you would have needed approximately five thousands sitting in your account.