Investing with options. It sounds scary to a lot of people. It also sounded scary to me before starting. Here is how I build up a little knowledge and experience in selling option premium. Let it be clear, I am still not a pro, I consider my self a one star rookie option seller.
Via a series of articles, I want to document my hands on experience with others. While trying to learn myself, I have found a lot of theoretical information, but what was missing was some step-by step insight of real trades.
Todays article will focus on why selling naked put options and why I do this.
Selling naked put options
Before jumping right in, I will explain briefly what a naked put option is about.
When selling a put option, the following happens
- between now and the option expiration date
- I promise – I am obliged when asked –
- to buy
- the underlying – a stock I selected (most often, you need to deliver 100 shares)
- for a agreed upon price – the strike price
- In return I receive a premium
A concrete example: If you write (sell-to-open) the following put: RD.P.16OCT15.AEX.AM.22, you are short 1 contract. As a result, then you have to deliver 100 shares of RDSA for a price of 22 per share, no matter what the shares are trading for at that moment. This obligations ends on October 16 2015 at 19:45. This info can be found on the contract options details.
Bear in mind, writing this put means that your broker will ask you some guarantee that you can buy the stock when assigned. Your broker will block some margin on your account.
Why would you sell naked put options?
For me, there are 2 reasons to sell naked options. But assume the same: There is a price I would not mind owning the stock for. This is an important rule: Be happy to own the stock at the strike price. It can not be stressed enough! It is a mistake I made before.
Other people might have other reasons to sell puts, but the 2 below are my main reasons.
Reason 1: I want to own the stock
Imagine there is a stock you want to buy, but at a price a little lower than it is trading today. Rather than entering a limit order, I write a naked put. I know, there are differences between both.
Not the least, I can cancel a limit order at any time, while an option contract, I need to find a someone who wants to sell me his contract to have a zero position (buy-to-close).
Secondly, with a put option, there is no guarantee that you will be assigned. Some people might have bought the put options as protection for their stock and want to wait until expiration. A limit order is very likely to be executed as soon as the stock breaches the limit.
In doing so, I get a credit, a positive cash flow. And this positive cash flow is the reason to write the option. I get money without owning the stock. And If I need to buy the stock, I need to pay less.
Reason 2: I just want to collect the premium
In this case, I write the put, assuming the stock will go up over the coming days and weeks. The cash that I get for this is extra return on my portfolio.
In practice, this case will require some more active follow up of the option trade. The end goal is not to own the stock.
The different scenarios of selling naked puts.
The price goes up.
In this case, the option will expire worthless. I get to keep the premium received as extra return on my portfolio. If I really wanted to own the stock, I miss out on a the price gain. So, If your main objective is to own the stock, then this is not the best possible outcome.
The price does not move
You get to keep the premium and you get another go to write a put options to own the stock or to make some extra return.
The price goes down a little
In this case, you are put the stock at the price you wanted to own it. Actually, you get to buy the stock a little cheaper: the strike price – premium and broker fees.
If the goal was not to own the stock, but to get the premium, Some option management would be needed in this case. I will cover this later.
The price goes down a lot.
This case is an extended case of the above. You are now probably owning the stock with a big paper loss. Are you happy to reach this point?
This case is for me the worst case scenario. I have been there a few times already. I will write out a concrete example on KO.
What are the reasons that you sell put options?
Before entering into option trading, educate yourself in the risk of trading options. Most brokers have a test that allows you to determine if you have the right knowledge and experience to do so. Why not consider paper trading for a while?