Monthly Archives: September 2011
The naked put, selling puts to accumulate stock
The uncovered or naked put is sold when an investor wants to produce income and is willing to accumulate shares of stock. The key difference between an investor and a speculator when it comes to naked put selling is that the investor is targeting a stock or ETF for a long term buy and has set a price that he is willing to purchase that stock at. The speculator is trying to profit by selling the put and hopes it will either expire worthless or he can buy it back later for a profit. The investor is satisfied with either outcome having the put expire worthless or getting assigned and purchasing the underlying shares at pre-determined price. Income is produced by selling out of the money put options at a price lower than the current price of a stock, when the investor would be willing to buy the stock at that price. For example, if XYZ stock is trading at $25, the investor is willing to purchase XYZ at $20. Therefore, she sells a $20 put for $1. If the stock stays above $20, the investor retains premium. If the stock goes below $20, it will be put to the investor at $20. However, the investor already has collected $1 in premium so her cost basis is $19. There are many sources that consider naked put selling to be a risky strategy. However, selling an uncovered put is not as risky as outright stock ownership. If an investor owns a stock that goes to 0, like General Motors, the investor has a total loss. If the same investor sold a put and was assigned on that put to purchase those GM shares, the investor would have retained the put premium even though the shares eventually went to zero. Naked put selling is riskier to the brokerage house because they fear that the investor may not meet the margin call if shares are put to her. If the investor utilizes proper position sizing relative to her portfolio and is using the strategy for stock accumulation uncovered put selling is not a high risk strategy and in fact has the same risk profile as the covered call strategy which is generally considered to be low risk. When stock prices decline, implied volatility has a tendency to rise making the options more expensive. If you’re targeting an entry price for a stock and see it decline rapidly, check the option quotes for a rise in the implied volatility and high prices for out of the money puts. When bad news comes out on a stock that you want to own, that can be a good time for selling out of the money puts. Say you’re willing to accumulate 1000 shares of XYZ over time. You could sell 10 out of the money puts and wait for the shares to get put to you or you could use a fraction of the total, say 2 puts per month and repeat the process until you’ve accumulated the full 1000 shares. When selling naked puts we target investments to accumulate, a price below the current market that we’re willing to buy them at and try to find puts that are relatively expensive. If you’re accumulating shares of a stock, puts will have a tendency to be priced high every quarter prior to the earnings release. This can create an opportunity for the put seller as the implied volatility rises to account for a substantial move in the stock. Out of the money puts can have a higher price at this time and provide an attractive entry point. For investors wishing to accumulate shares in a commodity based ETF such as USO, the oil ETF, the volatility can be higher before the weekly release of the petroleum report. Stock index ETFs can have higher implied volatility prior to major releases of
economic data like the monthly employment numbers or scheduled Federal Reserve meetings. When selling a put you can use the delta to approximate the probability of getting assigned at expiration. An at the money put will have a 50 delta, so if you sell an at the money put you have a 50/50 chance of ending up owning the shares. The at the money puts also have a relatively high premium and will have high theta. As the puts move out of the money the delta is lower so the probability of getting assigned also gets lower as you move out of the money. If you sell 20 delta puts the premium may not be that high, but you’ll only get assigned 20% of the time and your entry price into the underlying will be substantially below the current market price. If you are targeting individual equities with this strategy, you will only get assigned when the stock drops significantly, and you may decide you don’t want to own that stock anymore. It’s very critical to be sure you’re willing to purchase a stock when selling puts. When the strategy is used to accumulate ETF shares in a broad based index like the S&P 500 for example, by selling far out of the money puts on the index, you’ll only buy shares on dips and it can be a good dollar cost averaging strategy for share accumulation in an index fund.
SPY Short Put
The Covered Call
The covered call is one of the most common strategies employed
by individual investors. The covered call writer is moderately bullish to
neutral in his market opinion and is willing to sacrifice some upside gain in
order to collect the premium from the sale of the call contract. The risk of
the underlying stock position is reduced by the amount of the call premium
received. Call premium is received into the investors account as immediate
income. For example an investor may buy 100 shares XYZ stock at $25.00 and
subsequently sell 1 October $30 call at $1.25. At expiration if XYZ is above $30, the investor will have the stock
called away. When below $30, at expiration the investor will keep the shares, any gain between $25 and $30, and
the call premium of $1.25. Her cost basis in the stock is now also reduced to
$23.75, the initial price of the stock minus the premium received for the call.
Numerous academic studies have been done on the covered call strategy and one
of the conclusions drawn from them is that covered call writing can not only
enhance portfolio return, but the strategy has been shown to provide those
returns with lower risk. The volatility of the underlying fund or stock can be
significantly reduced by employing a covered call writing strategy. Since the
delta of an at the money option is 50 and the delta of the underlying fund is
100, if an investor sells an at the money option, the position delta is reduced
to 50, so that position has about half the risk of the underlying position as
long as the option stays at the money, as long as the price of the underlying
does not move very much. Another Greek that the covered call writer wants to
monitor closely is the theta, or rate of decay. The theta tells the option
writer how much money she’ll earn daily just through price erosion. At the
money options will have the highest theta. Say for example that an investor sells a
slightly out of the money option for $2 at the beginning of the month, not the
first calendar day of the month, but the first Monday following the third
Saturday of the month. If the underlying price stays steady or declines
slightly in the last week of the option’s life it may be only worth 5 cents.
Since the option’s theta is now only 5 cents and the investor has already
earned $1.95 in profit, it may make sense to buy that option back and sell the
following months slightly out of the money option and try to increase the theta
of the holding. In other words attempt to increase the daily income earned
through option decay.
