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The Good, the Bad and the Ugly of Option Writing
Posted by: Dr. Paul Price (IP Logged)
Date: July 12, 2013 10:48AM
Every investment technique can be useful in the right circumstance. Understanding how "short" options work adds a valuable tool to traders’ skill sets. Diversification in the way you structure your portfolio is often as important, in terms of your final results, as stock selection.
Using options magnifies the effects of stock movements. This higher volatility relates to the smaller principal amounts involved in option trades versus outright purchase of shares. This quality, known as leverage, is a wonderful thing when you are correct in both your assessment of future price movement and correct in your timing.
Leverage can be painful, though, if you are wrong on direction or timing. Employing proper strategy allows you to establish positions you can live with while waiting for the ultimate results to play out.
Following just two simple rules regarding put selling doesn’t guarantee profits. It does ensure you can wait around long enough to see if the reasoning behind the trade was valid.
Rule No. 1 applies to solid underlying stock selection based on fundamentals. If you can’t outline a well thought out case for a higher 6 to 18 month target price don’t play with the options.
Rule No. 2 is absolutely crucial. Never sell more puts than you could comfortably afford to have exercised. The dollar amount needed in an "if put" scenario should be reasonable in relation to the size of your typical equity position size.
If a normal size buy equals about $10,000 worth of shares, limit your put writing to one contract on a $100 strike, two on a $50 name, four on a $25 issue or 10 contracts on a stock priced at $10, etc. Everyone’s portfolio size is not the same. Prudent traders must right-size the number of puts sold.
Fight the urge to trade too large a quantity of options. Many people violate this principle by looking only at the premium received, rather than the "if put" commitment in dollars.
Here is a real-life example of a "stock plus puts" sale I made for my personal account just weeks ago.
Cognizant Tech (CTSH) has a stellar growth record yet had pulled back to relatively cheap levels in May this year. I bought 200 shares outright at $63.02 on May 17, 2013, while simultaneously selling three contracts of the January 2014 $65 strike price puts. My account was credited with a $7.50 per share premium for those puts.
On May 28, 2013 I went back and sold 2 additional CTSH January 2014 $70 put contracts. They represented an additional, bullish bet on the future movement of Cognizant Tech. For simplicity, those extra contracts will not be part of the discussion that follows.
Here is a chart I constructed to demonstrate CTSH’s cheap relative valuation just prior to the time of my stock and option trades. I was lucky enough to catch a weaker opening the next morning. That allowed for buying shares a bit lower than the previous day’s close. It also made for excellent put premium.
It cost $12,606 including commission for the 200 share purchase at $63.02. The sale of the three $65 strike price put contracts brought in $2,247 in net cash.
The shares have no specific time commitment. The puts have an eight-month duration before their Jan. 18, 2014, expiration date. The worst-case scenario for those puts would force me to buy another 300 CTSH at a net price of $65.00 - $7.50 = $57.50 per share. That would require a cash outlay of $19,500, if exercised, less the $2,247 I collected when I first sold the puts.
In the best case (CTSH closing at $65 or better), I’ll be sitting on paper gains of at least $1.98 per share on the shares I owned outright. There is no upper limit on how high that profit might reach. As of 4 p.m. on July 11, 2013, Cognizant was trading at $71.05.
In addition, and by definition, I will have made $2,247 on the expired puts without needing to have bought any additional shares.
The worst case scenario, in which CTSH closes lower than $65 on the expiration date, is not really scary at all.
The break-even price of the 500 total shares would be $59.74. That is $3.28 per share below the trade inception price of $63.02. Traders who positioned this way got a 5.2% margin of safety.
Neither technique can be judged right or wrong, better or worse, until you know where the shares close on the option expiration date. Here’s a "cheat sheet" to help you compare which does best under various final price points.
Option savvy traders possess alternative ways to play the same bullish opinion on the identical underlying company. It is always good to have choices.
Disclosure: The trades described were executed by me, with real money, in my personal account. I am long CTSH shares and short CTSH puts.
See my model stock and options portfolios here [marketshadows.com]
Stocks Discussed: CTSH,
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