Selling puts risk

Let’s take a look at my favorite strategy – selling puts. The risk is very low if you use this strategy against stocks you are OK to own. This is an alpha and omega of the entire trade. So let me repeat it.

You want to sell puts only against stocks you want to own at given price.

 
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If, for example, you sell a put contract against (T) at 34 strike, it means that you are OK to own 100 shares at 34 a share (minus premium). If you are not willing to buy such stock, then do not sell puts against it. That’s the only risk, you are taking.

Some people may tell you that you are taking a risk when the stock falls down too much or to zero and you get assigned. As this is true, ask yourself a question. How often this happens if you apply this strategy against dividend growth stocks? How often the dividend growth stocks fall so much down that you would change your mind and decide not to own it? Or that they would fall so quickly that you won’t be able to react?

As this may happen with small cap or biopharmaceutical stocks, it is not a case with dividend growth stocks.

 
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That is why I use put selling only and only against dividend growth stocks such as KMP, T, KO, MCD, LO, and many others.

How put selling works? If you sell a put contract, you are bullish and speculate that the underlying stock will be rising and will stay above the strike price. If that happens, the option expires worthless and you keep collecting premiums. If not, you will be assigned and you will have to buy 100 shares of your favorite stock at the strike price minus collected premiums.

For example, see the following two scenarios:

1. You buy 100 shares of (T) at 34 a share in January 2014 and you now own 100 shares. You paid $3,400
2. You also sell 1 June contract at 32 strike and you receive 1.5 or $150 premium

Let’s say that the stock drops to $31 a share in March and the other trader decides to execute the option early (which he will not with such a long dated option). What are your loses?

In the first case you are losing $300.

In the second case you are losing only $150
($3,400 stock purchase price – $150 premium – $3,100 new market price = $150).

 
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As you can see, put options are actually helping you mitigating your loss and they are less dangerous as when trading the stock outright. And if your options are expiring worthless several times, you can even make enough money to purchase your stock for free.

Here is a flow chart of the put selling strategy:

Why all the scary hype around options trading?

Why brokers are so scared to allow you trading this type of options? The roots of the problem go back to 2000 – 2003 during the dotcom bubble when almost every Joe Doe became a trader. Stocks were skyrocketing and everybody was selling puts, collecting nice premiums. Options were expiring worthless leaving traders with cash on hand. Everybody was happy. Traders were happy because of collecting fat cash premiums, brokers were happy because of fat interest charged for margin as majority of the trades were trading on margin.

 
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Then the tides changed and the bubble blasted. Suddenly, many margin traders who had not enough cash reserves to cover the short puts assignments started being assigned to stocks for which they had no money. They started to see margin calls. But who was actually on the hook? Who was the first to be hit? Well, it was the brokers!

They had to use their own cash to satisfy the options assignments and buy stocks at high prices on their clients’ behalf. After that, they could issue margin calls against defaulting accounts and take measures to collect their money back by liquidating positions or even trying to collect missing cash directly from the traders. In most cases they had nowhere and from nobody to collect cash as many traders went bankrupt.

 
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This is the reason why today the brokers have all sorts of heavy scary disclaimers. It is the reason why they will background check your financial situation to avoid their losses before approving you trading on margin.

Options trading can be safer than stocks if you learn how to use it

If you know how the strategy works and how to use it properly, you will never lose. Well, of course, you will have a few losing trades, but overall you will make money. And if you happen to have trades going against you, you will always have a plethora of strategies at your disposal to repair your trades.

 
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If you are interested in selling puts and want to try a trade or two, but need a guidance, shoot me an email. I will help you to set up a trade and take you through its entire life so you can see, how it works. If you want, we can use a paper money account and I can share my computer screen with you. You will be able to see a real life (paper or my own live) trade in case you do not want to commit real cash at this time.

Have a great time and happy trading!
 

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