Questions from an Options Rookie

12/24/2010 12:01 am EST

Focus: OPTIONS

Mark Wolfinger

Educator, MDWoptions

I recently received a few questions from a new option trader about selling puts on a stock you want to own (or wouldn’t mind owning). This is a good opportunity to outline how the process works.

First, the question:

Hi Mark,

I am inspired by your Rookies Guide to Options. I love this book. You are teaching in this book about selling CSP (cash-secured puts) in anticipation to buy stock at desired price, lowering your effective cost.

I have a question regarding this subject, namely selling cash-covered puts and covered calls.

Let's say that you want to buy a stock you want to own and the price is approaching support level, you sell puts, strike price is close to resistance. Few days later the price dropped below and you are assigned. This is fine. You own half of what you intended to buy. Unfortunately price keeps falling, you still want to buy additional half of the shares but you also want to lower your price and add options selling to accomplish that.

I understand that you can sell calls on your shares and sell twice the number of puts. Question is: how to manage this trade, at what price to sell calls and puts? At the same time? At the same price? Could you please explain this to a rookie?

Thanks,
Robert

Now, my answer:

Hello Robert,

Writing cash-secured puts (options on a stock you don’t mind owning if you are assigned the shares) is a worthwhile strategy. However, there is considerable risk when the market declines. That's why it's important to adopt this strategy only when willing to accept ownership of the shares.

Many rookies mistakenly believe that they will be assigned as soon as the option moves through the strike price. That does not happen. You won't be assigned so quickly. Do not expect to be assigned an exercise notice prior to expiration, unless the put option moves very far in the money (ITM).

Your plan is to buy more shares and you want to buy them at a reduced price by selling more put options. You also want to write covered calls on the shares just purchased.

You can certainly do that. The first thing you must understand about this process is that this is not an exact science. There are choices to be made. Let's see if I can help.

First, you must understand that you are adding to a losing position if you buy more shares. For some traders, that is something to avoid at all cost. For others, buying more shares—especially when they didn't buy all the shares they want to own—at a lower price has to be a good deal. By not buying the full quantity the first time, they are already ahead of the game.

You are obviously in the second group. I have no quarrel. Buying more shares is OK as long as you still want to own them. Remember this stock has broken support and is falling. For many traders, once support is broken, they unload the shares and take the loss.

However, let's continue by assuming you have made the decision to try to buy more shares.

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You have two separate trades to make and neither has anything to do with the other. You already own stock, and writing covered calls is a priority. In fact, you should have sold them as soon as you were assigned an exercise notice and owned the shares. There was no reason to wait.

All you had to do was choose the strike price and the expiration month. Making that choice requires some serious decision making. Because I know that you have my book, I suggest taking another look at the chapters on writing covered calls. They go into all the thought processes that I believe are necessary when making a good decision. Once you decide on the call to write, go ahead and sell the calls. It's unfortunate that you waited, and now the stock is lower. However, that's history. Decide at what price you are willing to sell the shares and choose an appropriate call.

As an alternative, ignore profit and loss. Look at the current stock price and pick an option as if you just bought the shares at the current price. Pick a good option to write. Don't sell any cheap options, e.g., don't sell options for $0.25. If you'd be happy to sell stock at the strike and if you are willing to accept the premium, then that's a good call to sell.

Buying more stock is another matter. Decide how much you are willing to pay and sell the appropriate out-of-the-money (OTM) put options. Example, if the stock is $48 and you want to buy more shares at $44, then choose a put with a $45 strike price and collect at least $1 in premium. You will either earn that $100 per put option or own the shares at a net cost of $44.

If the puts expire worthless, keep selling new puts, picking the strike price as you did above. Decide how much you want to pay and find an appropriate put to sell.

There is no reason to consider making these trades at the same time. It's okay if you do that, but why would you want to do that? When you are ready to sell the calls, enter the order. When you decide how much to “bid” for more shares, then enter the order to sell the appropriate puts. These are separate trades requiring separate decisions. 

There is no reason to consider selling the options at the same strike price, same premium, or anything else that you may have meant by “the same price.” 

Asking at what price to sell the options is asking the impossible. I'd have to know the stock price, the historical and implied volatility for the stock, how far out (in time) are you willing to sell the options. I'd also have to know more about your trade plan, i.e., what you hope to accomplish over time. Recovering losses is not a trade plan.

Keep one piece of advice in mind: Your goal is to make money in the future. Is this the stock that will accomplish that for you? If you believe the answer is “yes,” then go ahead with your plan. If the answer is “no” because this stock has fallen so far that you believe this is not the best stock to own, then abandon it and invest your money where you think you have a better chance to prosper today, tomorrow, and down the line.

By Mark Wolfinger of Options for Rookies Blog

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