Every trader has been put into that gut-wrenching position. Do you wait to buy or do you hold off on selling? Have you made enough of a profit or have you waited for the stock to fall enough?
People often display great skepticism at the convention of options trading. Most traders understand puts and calls — that is, most traders understand that calls are a way to highlight a bullish position in the short to long-term whereas a put is a bearish position in a similar timeline.
However, fewer people understand the convention of writing those two options and how far those can go as a viable navigating tool for your stock purchases or sales.
When it comes to entering or exiting positions, writing puts or calls can help take away some of that uncertainty.
Writing a put.
Effectively selling a put, this is a position that is opposite to the purchaser of a put. The purchaser is paying a premium to the seller for the purpose of making money on the difference should the stock price move downward. On the opposite side of that transaction is you, the seller of a put.
Let’s say, for example, that you love Walgreens Boot Alliance and you want to buy their stock. You’ve never bought their stock before, but you’re certain, in your mind, that they’re a winner. There is one caveat: You don’t know when to enter the trade. You do know you want to hold it long-term.
Let’s go into what it means for you, as a seller or writer of a put, in this situation. Puts and calls are traded in something called contracts. A contract represents 100 shares of that underlying equity. At a strike-price of $41, WBA puts are being sold and purchased between $1.24-$1.43. Let’s say that a seller of these puts sold 10 contracts to someone else at $1.30. This trade represents a credit to you for 10 contracts X 100 shares (for each contract) X $1.30. This contract credits you $1,300. The buyer of these contracts pays you this.
This isn’t counting the fees that the brokerage takes, either (usually around $.50 per contract).
Now comes the interesting part. If you truly love WBA, and, let’s say, that WBA stock closes at $41.00 on August 21, 2020, then you get to keep your $1,300 and you don’t need to do anything else. In fact, you can renew this position for next week doing the same thing. This is collecting a passive premium on a company you’d otherwise be purchasing anyway.
If the equity, let’s say, falls below $41, you can still make money. You’ll have options — pun unintended — with this path. If the equity falls between the difference of your premium, then you’re still making money and you can simply renew your option for the following week (or whatever interval you choose). In this specific case, that break-even point is going to be $39.70 (This calculation is just $41 (the strike point) subtracting away $1.30 (your premium received for selling the puts).
This line of action benefits traders that are looking to enter a position but can’t find a spot to enter from. Analytically, this helps cut down on a complete guess. Consider the reasoning:
- You are looking to buy WBA, and you were going to buy it today (at $39.71).
- Instead of purchasing WBA today, you sold 35 contracts at a strike price of $40. This effectively puts you on the hook for 3,500 shares X $40. You can subtract the premium given to you from the buyer, which would be around $1–2 each share.
Now let’s imagine scenarios that this plays out in:
- Let’s say, by next week or the week after, WBA trades at the same spot, right around $40. The buyer’s puts expire at $1.50 each, and you net approximately 3,500 X $1.50 = $5,250.
- Let’s say, by next week or the week after, WBA trades at $39 a share. The buyer’s puts are in the money, but the premium for them has decayed to $1 each (the difference between the strike-point and the current share value). At this point, you can purchase the puts back to close the position, netting you $.50 per share for 3,500 shares. That still earns you $1,750.
- Let’s say that WBA falls to $38. At this point, you can choose to buy the shares at the strike-point ($40 each share). But it’s not $40 per share. Subtracting the premium that the buyer paid you, you bought the WBA shares for $38.50 each for 3,500 shares. In fact, this is still a discount from your original entry point, which was $39.70. In this scenario, you technically have a loss of $.50 per share, but that loss is unrealized.
It’s important to remember that selling puts can put you on the hook for a massive amount of money. However, this was cash usually intended to purchase the stock anyway. In these cases, the risk is relative to that underlying theme. In my example above, Walgreens is a fairly stable company (meaning its volatility is extremely low). Because this is the case, there is also no volatility in their options pricing. When you sell 35 contracts, you are on the hook for 3,500 shares X $40. That’s $140,000. However, if you are looking to spend that money and you have the cash in your account for it, then it makes sense to move forward with whatever value you have in mind.
Whether it’s WBA or some other company you have in mind, researching its volatility is an important factor in determining how many puts to sell. Sometimes having a mixture of holding stock and selling puts to buy more later makes sense. Other times, if the company becomes volatile, you can earn more money by selling puts when those premiums begin to spike as well.
You can think about selling puts and tally up the dollars you earn over time passively in the process. Say you’ve earned, in total, $4 per share through contract selling. That’s effectively $4 per share gained but you’ve never held the actual stock itself. If your equity hasn’t gone up $4 per share, you’re ahead. In fact, you could blend some mixture of equity with put-selling to maximize that frontier.
But writing puts are only one half of the story. What happens when you eventually want to sell your stock?
Effectively the same as selling calls. You’ve put yourself in a profitable position. You’re in a position with Tesla, and you had 1,000 shares since last year. Your position has made you wealthy, but you have no idea how to exit because you don’t want to miss anymore upward price movement. On the other side of a call option is a buyer — this is someone who believes the price action will move upward and beyond the premium paid to you.
Selling calls creates that upper bound for you. It works in the same way that puts work, but, instead of creating a floor, it’s creating a ceiling.
You have an upper bound you want for yourself. You think $2,150 is a great price to sell your stock at. But Tesla is currently trading at a touch above $2,000. You look at the $2,100 strike point, and you decide to sell 10 calls.
A week goes by. Now, we have our event breakdown as we did for our puts.
- A week goes by, and the stock doesn’t move. This is great news for you because you get to gain $49,750 and keep your stock. Renew it for the following week or interval of your choice.
- A week goes by, and the stock moves up to $2,100. This is still great news for you because you get to gain $49,750 and keep your stock. Renew again.
- A week goes by, and the stock moves up to $2,150. This is the option’s breakeven, and you can either part way with your stock and sell at the price you wanted (because you wanted $2,150 and with the premium that’s what you’re now selling at) or you can buy the contract out at the breakeven and refresh a contract for the next term.
In any case, selling a call to exit a position yields you better control. If Tesla continued its upward trajectory, your gains were still made. In fact, if you were planning on selling at your price-point of $2,100, or even $2,000, you now sold it at $2,150 instead. In that perspective, you did better than you were going to do otherwise.
Who should be doing this?
The all-important question. In both examples, I tried to include a scenario where a trader either wants in on something they were already going to go in on or a scenario where a trader wants out of something they were already going to exit.
In either case, the trader already made the decision to get into their position. They were going to do them regardless of their awareness for these derivative instruments. And, that’s exactly the point. The instruments I provided above are something that’s available to everyone who has already decided they were going to enter or exit something. It helps aid that process and cushions the upper and lower bound. If you sold a put on something and ended up buying it because it fell too far, then that’s a discount from your original price-point. If you sold a call on something and ended up selling the stock because the price-point flew above and beyond, then that’s a benefit because your original price-point was far below whatever the strike-point plus the premium were, anyway.
In either case, there is a silver-lining helping to navigate you in a better way. At the end of the day, you don’t want to search for the absolute peak or the absolute trough, you really just want to be on that inflection curve.