Most people equate puts with a declining market.
Basically, buy puts if you think the market is going down. At least that’s the thought process for most investors new to options.
When you buy a put it gives you the right (but not the obligation) to sell a specific stock at a specific price (strike price) per share within a specific time frame. A great way to remember this is that you have the right to “put” stock to somebody.
What the industry doesn’t tell you is that options have a finite life and the price of the option you purchased steadily decays as it moves closer to its expiration.
And that’s why I almost always sell options.
So, What is a Put Option?
Let me explain using a brief example.
Below is the options chain for the S&P 500 ETF (SPY).
SPY is currently trading for roughly $195, so anything below $195 would be considered out-of-the-money.
Again, most investors buy options, certainly an inferior way to play options, but I’ll get to that later.
So, if most investors are buying out-of-the-money options, they would start at $194 and move lower. You’ll notice the price of the option decreases as you move further and further out-of-the-money . . . which is the appeal for the buyers of options.
Typically, the industry shows a trend of investors buying options with a 33% chance of success. The 190.5 strike would qualify as it has a Prob. ITM of exactly 33%.
By purchasing the 190.5 calls in November with 28 days left until expiration, an investor will pay the ask price of $1.94 per call contract (as seen in the chart above).
So, from the onset, unknown to most investors who buy options, they only have a 33% chance of success. Basically, SPY, which is currently trading for $195, would have to travel below $190.5 by expiration . . . certainly a daunting task for an option that is decaying in price exponentially as it moves towards its final destination , expiration Friday.
As a seller of options, and one who uses statistics as the foundation for all of my trading, I always want the probabilities on my side. So I have no problem selling puts to someone willing to take a 33% chance they will be right about their directional trade. I don’t have to worry about decay. I really don’t have to worry about anything other than if the underlying stock closes above the $19.5 strike at expiration. So, the underlying stock could move as low as $190.51, trade sideways, or move lower and I will make a profit. My chance of success . . . 67%.
Selling a Put
Selling a put obligates you to buy a ETF or stock at the strike price you sold the put on if the option is assigned. In some cases, you’re selling a put with the intent of buying the stock after the put is assigned. If this is your goal, then selling a put out-of the money makes the most sense because your hope is that the stock will move lower, below the strike price, and allow you to be assigned the stock at a lower price than where it was currently trading at the time you sold the put.
The options premium received for the put you sold will lower the cost basis on the stock you wish to purchase. Even if the stock doesn’t push below your chosen strike price, you still keep the premium for selling the put. Basically, you keep selling premium and lowering your cost basis on a stock until theoretically you own the stock for little to no cost.
Another great aspect about selling options is that you can choose whatever strike you wish to fit your risk/reward profile.
I prefer to go with a probability of success or Prob.OTM higher than 75%, in most cases above 80%.
I know this is a lot to grasp. Options aren’t easy, which is why they are typically reserved for the mathematically inclined. But this is where investing is headed and if you don’t take the time to learn about how to use options on a basic level, you are limiting yourself to a portfolio that relies on the market moving higher. Everyone can grasp this information. If you are truly interested in learning how to use options to your advantage then please do not hesitate to email me. I will make sure that you are on the right track and more importantly, comfortable using sound options strategies.
Try My Premium Service: Options Advantage
If you ever thought about delving deeper into the options market – and seeing my personal options trades and recommendations on a regular basis – I’ve got some great news. My premium trading service, The Options Advantage, is available now for 50% off the regular rate. Click here to subscribe.