Editor’s Note: Selling puts is a risky business.
It can pay off though if you know what you’re doing. So, read Karim’s advice on managing your risk below. (Ray-Bans and tighty-whities not necessary.)
– Amanda Tarlton, Assistant Managing Editor
Now that you know how to set up an account to sell puts, it’s time to learn how to successfully sell puts.
The first thing to do is have an honest conversation with yourself about risk tolerance.
To determine your risk tolerance, think about the following…
- How long you want to be in a position
- What level of return you’re looking for
- The level of discount from the current price that you’re comfortable owning the shares for, should you get put
- Your exit strategy, should things go against you
- The type of companies that you’re interested in owning if you get put
- How much of your portfolio you want to allocate to the strategy.
Once you set up your account and address all of these considerations, you’re ready to start put selling.
The Expiration Date Matters
With options, the more time before expiration, the more the option is worth. If you’re a buyer, you pay more for a long-dated option. If you’re a seller, you get more when you sell a long-dated option.
In today’s “fast money” environment, investors are impatient. Long term is now measured in months as opposed to years, and some investors can’t stomach the day-to-day movement in stock prices. So they either sell short-dated puts – ones that expire in a few weeks – or they just stay on the sidelines.
Here’s the problem with selling short-dated puts: They invite risk. If you take in cash from a put that’s expiring in a few weeks, you’ll either be disappointed with the amount of money you’ll actually take in or you’ll have to sell a put so close to the current price that your odds of being put are substantially higher.
This is why you need to be honest with yourself regarding how long you want to be in the position. The rule of thumb is that if you want a bigger discount to the market price, you will have to go out further in time.
This is not always the case because the premium you receive is based on volatility in the market. And when volatility is low, the premiums are much lower, unless you go out further in time. That can change if the market returns to normal levels of volatility or goes into periods of higher volatility, as it’s in now.
Back in 2008 and 2009, I sold puts that expired in less than a month, and I picked up more premium in a month than I could on the same stock a few months ago if I went out a year.
Going out further in time can be uncomfortable if you’re looking for safe trades. However, going out in time does not mean that you have to hold the position until expiration. The great thing about options, especially when you’re a seller, is that option premiums decline naturally thanks to price erosion.
In a recent trade, we sold puts with a five-month expiration period on a stock that was trading at $32. We received $650 for a 10-contract trade. Two months later, we closed out the position by buying back the same puts for less than $320.
The stock price when we closed out the trade was just under $32 – practically the same price. However, time premium was cut in half, and we walked away with more than 50% of the premium well before expiration.
As for the return on the trade, we saw a 17% return on margin in two months, which is a triple-digit annualized gain.
Time is important when you’re selling puts. But what is more important is the answer to this question: “If I get put, will I be happy or upset?” If your answer is that you’ll be upset, then the trade is not for you.