I have a confession to make – I am a major bargain shopper! When I enter a retail store, I make a beeline for the markdown/clearance items. I use coupons for everything from toothpaste to electronics. I also utilize this mindset when it comes to investing my hard-earned money in the stock market. One of my favorite ways to do that is through a short put option. Allow me to explain.
A buyer of a put option purchases the right to sell shares of the underlying equity at the strike price of the put during its lifetime. The buyer pays a premium for this right. Where does that premium go? It goes to the seller of the option who now has the potential obligation to purchase those shares at the strike price of the option during its lifetime. If the underlying equity remains at a price level above the strike of the put option, then the option expires worthless and the seller gets to keep that premium. If the underlying equity falls in price below the strike of that option and remains below through options’ expiration, then the seller will be assigned shares of the equity at the strike price of the option. The benefit here is that the seller will keep the entire premium received when the option was sold.
What is the risk in the short put option? It is defined as the strike of the put less the premium taken in on the sale of the option. When I sell the put, I am obligating myself (potentially) to purchase shares at that strike. If the company declares bankruptcy and the shares fall to zero, my short put will be assigned and I will have to purchase shares at the strike. I get to keep my credit, but I am exposed to loss down to zero. While the likelihood of this event is slim, effective risk management involves understanding the “worst case scenario” so that positions/risk can be managed accordingly. Keep in mind that when you own shares of an equity, your exposure to risk – assuming that you do not have a long put option in place as a hedge – is also down to zero. The risk you have in the short put will be withheld by your broker in your margin account.
Now back to my bargain shopper mentality… What if I sell put options on equities that I desire to own at a discount? I do my homework in the form of fundamental and technical analysis and determine what I believe to be bargain levels on equities I desire to own. Rather than buying the shares, I utilize the short put as a potential means of acquiring shares. If the equity doesn’t fall below my short put, then I get to keep my premium as profit and, if I choose, continue to short puts on the underlying going forward. If the equity falls below my strike price, I acquire the shares at that level and the premium I collected reduces my cost basis in share ownership. Let’s take a look at an example.
Let’s say that I have done my homework on Coach (COH) and feel that the fundamentals and technicals show that COH shares are close to bargain levels. With COH shares trading at $57.19 at the time of this writing, I am willing to take shares at a price of $55/share. I sell the November 2012 55 put and take in the credit of $60. If COH stays above 55 for the next two weeks, I will keep the $60 premium for a return of 1.1% in two weeks – without actually owning the shares. If, however, COH shares fall below $55 by options’ expiration in two weeks, I would expect to have shares assigned to me at the $55 level. My $60 premium will lower my cost basis and I will trade the shares going forward.
This is only one example of trading with the short put option. The key with all options strategies is to understand your risk and reward as part of your overall trading plan. At OptionsANIMAL, we teach you a myriad of ways to utilize options to your achieve your financial goals while limiting your risk. Talk about a bargain!