When a Short Put Trade Goes Wrong
12/19/2014 8:00 am EST
Today, options instructor Russ Allen, of Online Trading Academy, breaks down contingent liability, the obligation to buy the underlying stock and pay the strike price for it, if the stock’s price is below the put’s strike price when the put expires.
Selling put options short is a bullish strategy that can be quite profitable when we have a neutral to bullish opinion on a stock or ETF, and the premium levels for options are high. The idea is to collect a high price for selling the put options, which then deteriorate in value down toward zero as time passes. All goes well as long as the stock does not drop below the strike price of our short puts. As the puts decline in value, we can then either just allow them to expire worthless; or we can terminate the trade a little earlier by buying back (buying to close) the puts when they reach a very low value. By selling a put option short (i.e. without previously owning it), we receive money immediately, in exchange for taking on a contingent liability, the obligation to buy the underlying stock and pay the strike price for it if the stock’s price is below the put’s strike price when the put expires. If that were to happen, we would be assigned on the put and our contingent liability would become an actual one. We would then receive the stock and an amount of cash equal to the put strike would be removed from our brokerage account. In selling the put, we were selling insurance against a drop in the stock. If the drop didn’t happen, we keep the premium as pure profit. If the drop does happen, then we would have to pay up. You would only use the short put strategy if:
- You did not expect the stock to drop; and/or
- You believed the strike price of the put you sold, being lower than the current stock price, would be a good price at which to purchase the stock, in other words, you are truly willing to buy the stock at that price.
Your obligation to buy the stock can be secured by having all the cash in your brokerage account that would be required, should it become necessary. This would then be called a “cash-secured put.” If you have a good amount of experience in trading options, and your brokerage account is large enough, your broker may give you a higher approval level. In that case, you may be able to sell short put options without having all the cash in your account that would be needed to buy the stock. You will then be required to have as margin only about 20% of the total cash that would be required. Selling a put in this way is called selling it “naked” (as opposed to “cash-secured”). I’ve received a couple of questions recently on the short put strategy, regarding our alternatives in case the stock does drop substantially while we are in the short put position. Here are the questions: Question 1: After selling a cash-secured put, one possible scenario is that price drops to my strike and continues lower, breaking through the “original” demand zone where I was willing to own the stock. What can I do then? Buy the option back at a loss before assignment? Or get assigned, then stop out of the stock at a loss? Or something else? Question 2: [After selling SPY October puts at the 186 strike price] I ended up rolling my 186 puts out to the next week [when SPY dropped below 186]. That seems to be the best alternative I’ve come up with when sold puts go in-the-money. I’d like to hear your thoughts on the subject.
NEXT PAGE:A Chart Can Help
|pagebreak| To help visualize the example, here is a chart of SPY as of September 30, 2014:
At that time, it seemed unlikely that SPY would drop below 190 or so within a few weeks. Premium levels on options were high, meaning that the options were expensive. Selling puts with a strike price at 186 seemed to leave a comfortable margin. Say we’d sold the SPY 186 puts for $.50 per share. If SPY had ended up below $186 on the expiration day (October 17), then we would have received the stock and been charged $186 per share for it. Subtracting the $.50 we‘d received for the puts, our cost would then be $186.00 – $.50 = $185.50. This looked like a pretty reasonable price. But a couple of weeks later, SPY had dropped hugely. On October 15, two days before option expiration, the chart looked like this:
Our comfortable margin had evaporated, and SPY had traded as low as $181.92. The bargain price of $185.50 now did not look so attractive. Our next steps would depend on what our original objective was. If we originally wanted to own the stock, and it had not dropped so much that we were now ready to give up on it, we could simply stand pat and be prepared to accept assignment if necessary. We would then own the stock, at a net cost of $185.50. Depending on how long-term our outlook was, we might very well have decided beforehand that we would simply accept assignment in any case. As it turned out, this would have given the best outcome, since this ended up being the bottom of the selloff. But remember that during the day on October 15, the stock had dropped more than $3 per share below the $185.50 that would be our net cost, and we could not be sure that it would not drop even lower. If we did not really want to own the stock, but had sold the puts just to generate income, then we could take steps to avoid being assigned, and therefore being forced to take possession of the stock. We could do this by: a) Buying back the puts prior to expiration, and taking our lumps; b) Riding it out until expiration, when the stock would be forced on us; then dumping the stock; c) Or rolling out: buying back the puts, but trying to recoup some of the loss by selling more distant puts. Choice c) is what the reader who sent in Question 2 above did. When the stock dropped below his $186 strike price, he bought back the original 186 puts, probably paying $1.25-$1.50 per share. This was more than he had originally sold the puts for, so this trade showed a loss. But he then kicked the can down the road, by simultaneously selling short puts that expired later in time. He indicated that he used the weekly options to buy just another week of time. If he used the 181 puts (the demand level that had held so far), he could have received about $1.25, so the rolling out had resulted in his being out of pocket by not much, if at all. Eventually the 181 puts expired worthless, so he was home free with his original $.50 credit as his profit, minus the costs of doing the roll. This choice works well if the stock has not already fallen too far below the strike when you roll out, and if the bid/ask spread on the options is not too extreme. It gives you a temporary stay of execution, which can become a full pardon if the stock recovers. The costs involved in rolling out include the commission to buy back the old puts, the commission to sell the new ones, and the bid-ask spread on both. These costs can add up quickly, so you cannot roll too many times in succession. Rolling once or twice might save the trade though. Choice a) above (buying back the puts prior to expiration) would terminate the trade with a fixed and known amount of loss, in this case about $.75 per share. It may be cold comfort to know it, but this loss is less than that you would have sustained if instead of selling the puts originally, you had owned the stock. The puts cannot have gone up in value by more than the stock went down. This is the cleanest exit if you now believe that the stock has entered a longer term downtrend. Finally, there is choice b) Riding it out until expiration, when the stock would be forced on us; then dumping the stock if it was still below our stop price at that time. This would end up being the best choice if the stock recovered, since we would then still keep our original $.50 credit as profit. But it would be the most costly if the stock did not recover, but instead continued down. We would be in the stock at a net cost of $185.50, and the value of the stock might be much less than that. Rolling out can be the best option, unless you are now convinced that the stock is finished with its long-term uptrend, or the option is now deep in-the-money. If the put is very deeply in-the-money, then there is yet another alternative, which we will leave for another day. It boils down to how confident you are in your opinion on the future direction of the stock.
By Russ Allen, Instructor, Online Trading Academy