Contrasting Selling Naked Puts to Limit Orders

To contrast selling a put option with placing a limit order, let’s say you want to buy 100 shares of IBM 125,93 +1,04 +0,83% for $140 ($14,000), which is now trading at 140.08.  You could place a limit order for 140 and hope it is executed, or sell 1 put contract.  Let’s go through the selling a put.

Currently, the Nov 6th (weekly) 140 puts are bid/ask 1.93/2.02, or 1.98 mid.  You could sell 1 naked put instead of placing a limit order.  By selling the contract at $1.98, you’ll receive $198 no matter what happens.  If your commission cost is $1.50/contract, that’s $196.50 you immediately receive!

Now, the contract may or may not be exercised.  It is the buyer of the contract who chooses whether or not to exercise, and in this case, they have until Nov 6th to decide.  In American style contracts, the buyer can exercise at any time, whereas in Europe, they can only exercise on the day of expiration.

In this case time value at time you sold the contract, is $1.98 – ($140.08 – $140), or $1.90.  For this reason, the buyer doesn’t have a lot of incentive to exercise, because they could be better off selling the option for $1.98 and then buying the stock.  So, the bigger “risk” is that you won’t get the IBM stock you might of had if you placed the limit order.

If you REALLY want the IBM stock bad, you can choose an earlier expiration.  Stock options expire on a Friday, every Friday if they have weeklies, which IBM has, or just the 3rd Friday of the month if the stock only has monthlies.  Because today (10/30/2015) is Friday, and the market ended today, the next option expiration is 7 days away.  But, if you did this on a Thursday, you’d have a much higher chance of being exercised if IBM is at or under $140, making it more like a limit order.  But, because of time decay, you would receive less premium on an option that expires in a day.

Conversely, if you wanted and was willing to buy IBM at $140, but valued the premium more and would be happy to get a nice premium even if you didn’t get the stock anytime soon, you could just pick a later expiration date.  You could, for instance, collect $293.50 selling a Nov 20th 140 put.

You could even collect $2050 selling a Jan 2018 IBM 140 put.

What happens if IBM never comes down to $140?  Well, if it expires, you keep the premium.  Your buying power is now freed up to buy another put, or invest it elsewhere.  But, what if you sold the Jan 2018 put, and 6 months later IBM is at $145, and you want to buy it?  First, presuming volatility hasn’t changed, your time decay will have lowered the value of the put.  The increase in IBM’s price will have also lowered the value.  So, with 6 months of decay and a higher IBM stock price, you might be able to buy it back for $1000 (guestimate), keeping a $1050 profit.

What if IBM drops below $140?  Well, then the put increases in value (offset by time decay).  So, it is possible that the option could cost more to buy than what you sold it as.  However, again presuming volatility hasn’t changed, it cannot be worse than if your limit order executed at $140, you held the stock, and it’s price dropped.  In other words, if IBM is now $135, your stock value would have dropped by $500.  But, your put would of increased by less than $500 due to time value remaining.

I’m leaving volatility out of this because it can impact the price day-to-day, and can work in either direction.  Simply put, increasing volatility puts upward pressure on option prices, and lower volatility decreases it.  That is why you ideally try to sell options when their volatility is high, and buy them when their volatility is low.

But, when you are talking about a lot of time decay (6 months in this example), or a big change in the underlying stock price (-$5 from $140 in this example), volatility may not be the largest factor in the option price change.

delta = changes in underlying stock’s value’s impact on option price
theta = time value, which decreases the option’s value as it approaches expiration
vega = volatility, which increases the option price when it increases, and decreases the option price when it decreases

The biggest mistakes BUYERS of options often make is:

1. They don’t understand volatility’s impact on price, and buy an option when it is high.  Volatility can drop quickly, leaving them baffled on how an option they just purchased dropped in price so fast.

 

2.  They quickly figure out that time value is not on their side.  Time value always rewards the seller of options, not the buyers.

A buyer of an option that wants to make a profit is hoping that the detla (change in stock price) moves enough in the direction they want it to move and/or volatility increases (vega) enough to offset the inevitable time decay (theta).

Conversely, a seller of an option hopes that that the underlying either does not change much or changes the other direction the buyer wants it to move, while theta does its job.  A seller lowers risk by selling when volatility is high, as well.

In terms of delta, the seller has the upper hand because whereas the buyer primarily needs the stock to move enough in one direction to break even before expiration, the buyer will not only win if the stock moves in the other direction, the seller also wins if it doesn’t move at all, or, even if it moves in the direction the buyer wants, but just not “too much”.  “Too much” is the difference in the price at the underlying when they sold the option, and its stock price, known as how far out-of-the-money it is when you sell it.

In other words, when you sell XBI 59 puts while XBI is $65, you will make maximum profit if XBI is at least 59 when the option expires.  This option is $6 out-of-the-money at time of sale.  That means if XBI goes up, you win.  If it stays the same, you win.  If it goes down $6, you still won.  If the options cost $1, the break even is actually $58.  So, the buyer only wins if it goes below $58.  You only lose if it goes below $58.  Considering it is at $65 at the time the option is sold, clearly, the seller always has the greater range in order to win.

The max loss if you place a limit order and buy the stock at $140 is $14,000 for 100 shares.  The max loss if you collect $198 selling a put, and it is exercised (you have to then buy it at $140) is $14,000 – $198, or $13,802.  So, the risk is higher if you buy the stock outright than it is if you just sell the put, due to the premium you collect.

The only downside to selling a put is you limit your profit.  If IBM soars quickly to $150, the stock holder will benefit, but the seller of the put, while being happy because the put will safely drop in value and risk of being exercised, will not gain the value of IBM soaring.  But, the option seller, in this scenario, can quickly close the position at a profit if expiration isn’t near, and then reinvest the capital in another investment.  If you hold your position an average of 4 weeks, then that’s 13 times you’ll re-invest it in a year.

Is a naked put too risky? Consider a vertical spread, instead.  With this,  in addition to selling a put, you’d buy a further out-of-the-money put as protection to limit your loss.  Note that this will reduce the credit you’ll receive by the cost of the further OOTM put.  But, buying a put with a strike of 135 along with selling the 140 will cap your max loss to $5 per share, or $500 for 1 contract.  This can also potentially limit how much buying power your broker reduces from the trade, freeing up more capital to invest.

Note that with indexes and index ETFs, unlike individual companies, indexes never go to $0, although there is some theoretical risk that an ETF can become insolvent.

 

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About Erik S

With a passion for Investing, Business, Technology, Economics, People and God, Erik seeks to impact people's lives before he leaves. Contact Erik
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