Options Strategies for a Volatile Market (Part 3)

09/25/2008 12:00 am EST

Focus: OPTIONS

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

Short Puts

Selling, or writing, options is one of the most effective strategies available to options traders. Among the advantages is the fact that time value, over the length of the option’s life, melts away in your favor. This happens because the closer you get to expiration, the less time the option has to reach a profitable price, making it less valuable to buyers.

In this lesson, we will cover two option selling strategies from a risk and reward perspective, and learn how they relate to other strategies you are already familiar with from this course.

Did you know that selling a put has the same risk profile as a covered call? That surprises most traders when they first begin to understand how this trade works.

In fact, over the long term, selling a put can be as effective as a covered call from a volatility perspective, plus it can also reduce trading costs. This is because a short put only has one position—the put—instead of the two positions (the long stock and short call) involved in a covered call.

Selling a put is essentially a bullish strategy. It’s bullish because you are the seller and are hoping to sell the put now for a high price and then let it expire worthless or buy it back later for a lower price after the underlying stock has risen.

If stock prices rise, a put will decline in value and ultimately, any put that expires out of the money is worthless. That is a great position to be in as the put seller because you keep the premium, with no obligation to deliver any stock.

I mentioned previously that selling a put is similar trading a covered call. Let’s discuss this strategy by contrasting the two trades on a single stock.

Assume that you think gold prices are going to rise in the long term. The streetTRACKS Gold Shares (GLD) follows gold prices as an ETF. As you can see in the chart below, GLD has been on a nice uptrend over the long term and is currently sitting at support for $85.59 per share.

Because you are bullish, you could trade a covered call here, or sell a short put. We will detail each trade alternative and look more closely at the results of two possible outcomes below.

Pizz Chart

Covered Call Entry Trades:

1. Bought 100 shares of GLD: $8,559
2. Sold 1 contract of 86 strike call, 30 days expiration: $250 premium

Short Put Entry Trade:

1. Sold 85 strike put 30 days expiration: Collected $230 premium

What happens if the stock rises to $90 by expiration?

Covered Call Exit Trades:
1. Sell 100 shares of GLD at exercise for $8600 (the strike price of the call)
2. Keep the $250 call premium
3. ROI: 3.3%

Short Put Exit

1.Put expires worthless; you keep the $230 premium.
2. ROI: 2.7% (assuming you left $8500 in your account to cover losses)

Now, what if the ETF (GLD) falls to $80?

Covered Call Exit—Scenario Two

1. Keep the stock with a loss of $559
2. Keep the $250 call premium
3. Losses: -$309

Short Put Exit—Scenario Two

1. Buy back the put at expiration for $500
2. Keep the original premium of $230
3. Losses: - $270

You can continue to work through scenarios on your own to contrast the two trades. If the put’s strike price is equidistant from the current price of the stock as the call’s strike price, the short put will lose a little less to the downside but has a smaller maximum gain on the upside.

That is the situation we saw in the example. In the live market, the prices and situation will obviously vary. The reason both trades have the same risk is because the exposure to the downside is the same. As the stock falls in value, a covered call trader will lose on the stock. Similarly, as the stock falls in value, a put seller will accumulate losses as the put rises in price.

By John Jagerson, of PFXGlobal.com and LearningMarkets.com.

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