Explore Your Options
| Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the STOCKS & COMMODITIES website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C. |
Tom Gentile of Optionetics |
SELLING TO BUY
I've heard the term "selling to buy" when discussing put options. I am not sure what it means and when to apply it in my trading.
If you are selling to buy, you are selling or writing options and are willing to buy the underlying security. The most common way of doing this is to sell puts on stocks you want to own. For example, if I want to buy a stock for $50 a share and the stock is currently trading at $50.50, I can sell put options with a strike price of 50. Depending on how much time is left until expiration, I might get a few hundred dollars per contract for writing the put.
If the stock falls below the strike of the put when expiration approaches, I will probably get assigned on the contract. That is, for every put option I wrote, I will be asked to buy 100 shares for $50 a share. They are putting the stock to me. That's okay, because I wanted to buy it at that price anyway. However, if the stock does not fall back toward $50 when the option expires, I can keep the premium for selling the put option. Then I can write another one.
So selling puts to buy stock is one way to "sell to buy," sometimes called "naked" put writing. For a prospective stock buyer, it might seem like a no-lose situation. Either I buy the stock at the price I want or I keep premium for selling puts. Is there a downside?
There are two important considerations when selling puts to buy stock. The first is that the stock might never fall back to the strike price and if so, the put won't be assigned. Consequently, if owning shares is the purpose of selling the puts, there is a risk of never being assigned the stock and possibly sitting on the sidelines as the stock rips higher.
Second, there is another risk if the stock makes a sudden and unanticipated move lower. If the stock price sinks, the put writer will be on the hook to buy the stock for the strike price, no matter what. In our example, suppose the company's executives get indicted for fraud and the financial statements must be completely restated. The news sends the stock reeling from $50.50 to $20 a share, never to recover. The put gets assigned and, for each put, 100 shares of the stock must be purchased for $50 a share. It can then be sold in the market for only $20 and a $30 a share loss, or $3,000 per put option. Recall that I only took in a few hundred dollars for selling the put.
So rather than sell naked puts, we generally buy a put with a lower strike to limit some of the risk. Doing so sets up a credit spread known as a bull put spread. In this example, we might buy the put with a 40-strike price. It will probably trade for little money (like a nickel or a dime per contract) and serve as disaster insurance if the stock falls. Buying the put will also lower the margin required for the trade and tie up less capital.
In conclusion, selling to buy is often used to acquire stock through the assignment of puts. It can be used to buy stock or step into other strategies like protective puts, covered calls, or collars. While the idea of selling naked puts might seem appealing because of the income it generates, it can also create big percentage losses if the stock makes an unexpected move lower. Thus, it is often better to use credit spreads rather than simply selling uncovered puts.
PROTECTIVE PUT OR LONG CALLS
I recently realized the protective put has the same risk-reward as a long call. Why would anyone use a protective put rather than a long call? Buying the stock and the put ties up so much more capital.
The protective put and a call option with the same strike price on the same stock will have the same risk curves. In option jargon, they are synthetic equivalents. Where a long call simply involves buying call options, the protective put involves buying shares and holding puts. Both trades will make money if the stock moves higher. However, the premium for the call option will be a fraction of the stock price. In addition, buying calls involves one commission. On the protective put, the trade involves two commissions -- one for the stock purchase and one for the put purchase.
So in many cases, it makes more sense to buy the call than set up a protective put -- if the goal is to participate in a stock's move higher, but with the risk limited to the premium paid for the call. On the other hand, if the goal is to own shares for the long term and use puts as a short-term hedge, then the protective put obviously makes more sense.
TIME CONSTRAINTS
I want to trade options, but I don't have the time to monitor the market throughout the day. Can I still make money trading options?
Understanding how much time you can commit to the markets is an important part of developing a trading plan. If you can only research and trade the markets once a week, your trading approach should be based on weekly time frames, not days or minutes.
Fortunately, there are a number of ways to use options over different time frames. Puts and calls are not just for short-term traders. In fact, as of this writing, there are options that expire as far away as January 2010 -- or roughly two and a half years from now. Consequently, it is possible to develop option strategies with both short- and long-term objectives.
Originally published in the August 2007 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2007, Technical Analysis, Inc.
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