Selling Put strategies

Last night in the webinar the question was brought up about selling puts. I have discussed this on the blog before (see the archives) but this should be another good time to discuss this. In fact I was about to post an article about this this weekend at ezine.com So I will just copy here and paste it there.

Puts as we should know give the owner the right to sell a particular underlying (stock, ETF etc.) at a given price. Example, July 20 put give the holder (owner) of this option the right to sell this stock at 20 before the 3rd week of July.

This also obligates the seller of this put to buy this from the put owner at the given price. In our example, the seller of this put is not obligated to buy the shares at 20 if assigned. There is always another side to a trade.

Now to do all of this, there is a premium involved. Much like insurance (in fact this is what options are is passing on risk to someone else) so if I want to own the right to sell at 20 by July, then I have to agree upon a premium to pay for this right. The trade grating this right is taking the premium to allow this. (again much like you car insurance, they take your premium each month for you to have the right to present claims in the event of an accident)

Now that we have the basics behind us, let's look to a few neat strategies.

Now if I expect a stock to go down, I can buy the put and sell the shares to some one at 20 and then buy back the shares some time in the future at a lower price (selling higher and buying lower)

The premium for this would be less than margin for the (20x100=2000/50%)

Now if we want to own a stock and we sell a put, there are 2 things that can happen. The stock rises above 20 in which case we will not exercise the option and just walk away with the total premium we collected, or the stock drops and we get assigned, so we own the stock for less than we could have bought at the current market, because we now own it for 20 less the premiums we received.

Now here is where most that teach this or use this strategy give it a disservice.

You do not have to get assigned just because the stock drops. We have what is called time value.... as long as there is time value we will usually not get assigned. so we can now buy back the options we sold for a loss, then sell the next month for a gain (this is called rolling out). we can do this month after month until re get the shares fro free or the stock ends up above 20.

If we do this strategy on say Ford (F) which is at 6.27 as I write this. So by selling the July 6 put. for .39 cents. we are now obligated to own ford for 5.61 (6 strike less the .39 premium. to do this we would need in our account around 300 dollars (yes this would be a margin trade so you may want the entire 600 set aside for conservative traders) That is over 10% return less than 6 weeks.

Now if Ford drops below 6 the put premium will go up so we will be losing on our July put. However, we can now roll to Aug. (unfortunately for our example Aug is not trading for 2 more weeks) But if we look at today's pricing of July/Sep we can get the idea of rolling out. The spread between July /Sep is about .30 (we buy back July for .39 and sell Sep for .68

If Ford stays where it is at for 10 months, we have a free trade (.30x10=300-300 margin).

Don't get flustered it takes time to grasp this. but it is fun to do. The single most important underlying factor to this trade is that ford will be around for 10 months. Countrywide would be an even better example given the fact that B of A has the Green light to acquire them. Look at the return on this one. 5.00 strike sell for .41 (on a margins account of say 250.00 in the account to bring in 41.00 for less than 6 weeks is better than a poke in the eye......