In Part 1, Michael Thomsett explains the background of the options market and why options provide tremendous flexibility for all types of traders, even the highly conservative. To read Part 1, click here.
A Creative Strategy: The “Double-Whammy” Short Put
Selling puts is much less risky than selling uncovered calls. In theory, a stock’s price could rise indefinitely, making short calls a problem. However, with a short put, you reduce risks in two ways. First, a stock’s price can only fall to zero, limiting the worst-case outcome. Second, on a practical level the true floor for a stock’s price is its tangible book value per share. (Price can fall below this level, but it is unusual.)
Selling puts creates a “double-whammy” strategy and helps you to manage your portfolio. The first part of this strategy is generation of cash. When you sell, you receive money. This not only adds cash to your account, but also discounts the exercise risk. For example, if the strike price is $20 and you get 3 ($300) for selling a put, you have reduced the potential risk level to $17 per share. To avoid losing money on the position, you can close the put or roll it forward. Or you can simply allow the in-the-money put to get exercised, so that you acquire 100 shares above market value. (As long as the stock’s current market value lies between the strike and the discounted value, you don’t lose money. In the previous example, the discounted basis would be $17 per share, so if the current value is at $17 or more, you do not lose money due to exercise.)
The forward roll – buying to close the original short put and selling another expiring later – is an effective way to avoid exercise. If the stock’s value has fallen since the time you opened the short put, you can also roll forward and down to a lower strike. This not only avoids exercise; it reduces the basis if and when the short put is exercised.
Selling puts does contain risk, although it is limited. This strategy should be used only when (1) you consider the price (strike price minus put premium you receive) to be a good price for the stock; (2) you would be happy to acquire shares, meaning you have qualified the company and its fundamentals as a stock you would be happy to own; and (3) you fully understand the risks in the strategy and consider the put’s premium justified by the fundamental attributes of the company. (The dollar value of premium also affects the decision. For example, if you can sell a put for only $18, is that enough to justify the decision?)
If and when exercise does occur, you can immediately enter into more strategies. These include selling another put to increase your holdings; writing a covered call against the long stock; or entering an advanced strategy like a short straddle. (As long as you own 100 shares of stock and write in-the-money calls and puts, the short straddle consists of a covered call and an uncovered put. This generates maximum cash (discounting basis) for fairly low market risk. So the strategy doesn’t stop at exercise or expiration; it is only the first step in what can easily become a profitable and effective portfolio management system.
When you analyze specific strategies to maximize leverage while holding risks in check, avoid another mistake: Don’t get caught up in the dollar value as much as in the actual yield, compared on an annualized basis. Getting a higher premium is not always the best way to go. For example, a premium of $300 for a stock with a $20 strike is a 15% return. But if you have to wait 24 months until expiration, the annualized return is really 7.5% (to annualize, divide the rate of return by the holding period, and then multiply by 12 months: 15%/24 x 12). In this case, you get a better return selling a three-month put for $100 (yield is 100/2000 = 5.0%), but annualized it is 20.0% (5.0%/3 x 12 = 20.0%). So the $100 premium is actually a better rate of return than the longer-term $300 premium.
The comparison of returns on an annualized basis helps avoid common mistakes that even seasoned options traders make. This is especially important when studying advanced strategies like the “double-whammy” put or the short spread. It is all too easy to lose sight of the desired end goal, when the immediate prospect of rich premiums can cloud your judgment. The best way to make smart comparisons is to annualize before you analyze.
Conclusion: In the past, before the days of the Internet and online discount brokers, options were not practical for a majority of traders. Today, this has all changed. Transaction fees are lower than ever before and you do not need to place orders through a stockbroker or even a floor specialist. Today, every trader can place trader directly and, usually, see orders filled almost instantly.
Devising good portfolio management strategies relies on three key attributes. First, risk levels have to be acceptable. Second, the strategy should meet your investment and trading goals (including being willing to acquire shares of stock in the future). Third, anyone entering a strategy should understand the risks and the full range of possible outcomes.
Options truly are the product for the age, allowing everyone easy access, affordable fees, and a range of strategies you can fit to your own risk level. The flexibility of options allows you to tailor a strategic program to suit your needs and to serve as a good fit for your personal level of risk tolerance. The same cannot be said for any other product.
Michael C. Thomsett is author of over 70 books in the areas of real estate, stock market investment, and business management. His latest book is The Options Trading Body of Knowledge: The Definitive Source for Information About the Options Industry. Thomsett’s other best-selling books have sold over one million copies in total. These are Getting Started in Options, The Mathematics of Investing, and Getting Started in Real Estate Investing (John Wiley & Sons), Builders Guide to Accounting (Craftsman), How to Buy a House, Condo or Co-Op (Consumer Reports Books), and Little Black Book of Business Meetings (Amacom). Thomsett’s website is www.MichaelThomsett.com. He lives in Nashville, Tennessee and writes full time.