by Jerry Lee
CHAPTER 14
HOW TO AVOID PROBLEMS WHILE SELLING PUTS
The rules I now use to help me avoid problems are simple, straightforward, and easy to understand. I have never seen these rules written down. I am sure most successful traders use some sort of rules to limit their losses and help them in the decision process, but I have never seen these in print.
I have found that it is easy to make a decision when entering a position and extremely difficult to exit a position without rules. You will have to learn to take your emotional side out of the picture. Losses will be part of trading, but your job is to limit them. You must expect that some stocks will not follow directions. I have had losses from positions where things just did not go right, even when a stock and option passed all of my filters—the stock just did not perform as expected. When that happens, and it will, follow the directions below and cut your losses to a minimum.
Using Stops to Prevent Disasters
Stops are a predefined situation where you will, either manually or by an order that you have installed with your broker, make a trade to limit your losses. This order can be implemented in several ways. The two most common ways that stop’s are used with puts sellers are as follows.
Example: You have sold a June put on ZZZ stock at a strike price of 40. When you opened the position, ZZZ was trading at $50. If you are going to be away from the market, you could put in a “stop” order that might read as follows.
If ZZZ stock gets to $45 or lower, close my ZZZ put position by buying my put to close, at the market. You are now somewhat protected. ZZZ stock can start falling, and your options price will not get to far away from you. You have limited your loss to whatever the current options price is when the order is filled. This also left some wiggle room for the stock to move up or down somewhat and not trigger your stop order too soon.
Another way you can use stops is by putting the order in, but instead of using the stock price, you will use the option price.
Example: You sold a put at fifty cents. The option is the June put for ZZZ stock at the strike price of 40, but since you are going to be away from the stock market, you want a protective stop in place. Your order might read as follows: For the ZZZ put, at the 40 strike price, if the ask price is ever at, or above, eighty cents, buy the put to close, at the market price.
This prevents the options price from running away from you. You would hate to turn on the computer and find the options were now trading at $5, etc. You now have a stop in place.
Rules for Closing a Position
These are the rules that I follow for stops. There are only two, and they are easy to learn. They will make your decisions easier and more straightforward.
Rule 1. If the premium doubles, close the position!
In the previous example of AMGN, I sold a put for a thirty cent premium. If the premium ever gets to sixty cents, I close it. Period. No argument! This will stop the bleeding. When you get used to making that decision, you will find immediate peace. The decision has been made; now go find a stock that will work.
Example: You sell a put for thirty cents. Two weeks later, the stock starts to drop and the put option starts to go up in price. If the ask price of the option ever gets to sixty cents, close the position. It does not matter, where the current stock price it. Close the option position.
Rule 2. If the underlying stock price drops to the strike price, I also close the position.
Assume that I opened an option position when the underlying stock was trading at $50 and I had sold a put at the strike price of 40. Regardless of the option price, I will never let the current price of the underlying stock get below the 40 strike price I am using. Never! Once a stock has dropped below the strike price, your put option is now in the money and losses can mount quickly. Again, do not argue with yourself. Buy the put back for a loss if necessary, but do buy it back! After my experiences in 2000 / 2002, I will never again let my put position have any intrinsic value!
Following these two simple protective stops, let us look at a month where all of your positions went against you.
Example: You had an account of $50,000. You followed my recommendations and averaged about 3% return the first month. Therefore, the cash you took in would be approximately $1,500. If you cut your losses when each premium doubled, then the total cost for you to close the positions would be $3,000. Of the $3,000 cost, $1,500 was part of your income when you opened the original position. Therefore, your actual account would only drop to $48,500.
$50,000 + 1,500 - 3,000 = $48,500
The above example is an extreme case. I should mention that I have never had all of my stocks go against me at the same time, even during the bad days.
Using Time for Your Advantage
Remember, when you are dealing with options, they are very time sensitive. Therefore, the less time that your positions are exposed to bad news, the more your option premiums should dwindle to nothing and expire.
There is a common saying with options traders: when buying a put or call, buy lots of time, as you want your dream to have as much chance “time” as possible to happen. This means, if it is July when you open the position, you might buy the January call or put.
When selling a put (my method), you allow as little time as possible for the other traders’ dream to happen. The trader on the other side of your trade is betting your stock will drop. I am going to give only a maximum of thirty days for this to happen, and then it has to drop over 20%.
Another Common Question regarding the selling of puts.
What is the danger of being “put to” or assigned?
This is a very common question. It is also one of the most misunderstood parts of selling puts. Although you can be assigned “put to” at any time after opening a position, there is little danger of this happening until the third Friday of expiration month. Why? Because there is more money in trading the options than in trading stocks!
Now that I have your attention, let me explain. Pretend the underlying stock price has dropped to 100 and you have sold the 105 strike price. Common sense would say that someone who has the other side of the option position would make you buy the stock for 105 when it is only worth 100 on the open market. Look at the numbers to see why this might not be so. The person who has the other side of the trade has a choice. He can make you buy the stock for $105 and make $5 (he probably does not have the stock but must go on the open market and buy it for 100, and assign the stock to you for the 105 strike price).
With a week until expiration, the option might be selling for approximately $6 ($5 intrinsic value and $1 time value). If he can trade the option for a $6 profit, or the stock for a $5 profit, guess which one wins. When a lot of time is left in the option, the time part of the premium will be even larger.
As time decreases and expiration day (third Friday of the month) arrives, then the option premium will reflect more closely the true spread (parity) between the stock price and the option strike price. The premium will be made up of nearly all intrinsic value.
Using the above example where the stock is at 100 and the 105 strike price is used, then on Friday morning of expiration day, the option will be selling for about $5.05 to $5.25 (the intrinsic value of $5, plus the small amount of time value of $0.25). Well, now you are in the “getting put to zone.”
Obviously, you always used my Rule #2 regarding stops, so you would never have let the stock price fall below the strike price you had chosen! If you have questions about that part, refer back to Rules #1 & 2 earlier in this chapter. Assignments are done at the closing of each day. You have until the close of a trading day to make various trades if you are worried and want to close a position.
When selling puts, you will never be put to (assigned) if the stock price is above the strike price.
If you have sold a put at the 80 strike price and the stock is now trading at $80.50, the trader who has bought the put will not force you to buy the stock for $80 when he can sell the stock on the open market
for $80.50.
Here is another point. Let’s assume that someone owns ten puts, for whatever reason, he decides to have them assigned. He will notify his brokerage that he wants to exercise his put position. The brokerage notifies the options board (OCC), and they will divide these over many different brokerages. Five different brokerages might get two each. Each brokerage will then use some type of system to further divide these among their clients.
Another important point: most people (if not nearly all) who buy puts, do not have the underlying stock that could potentially be put to you.
Example: Joe Smith buys ten puts on ZZZ stock for the 45 strike price. Remember, Joe does not have the stock, just the puts. The stock was currently trading at $50 when he bought the options. The options cost him thirty-five cents each. Say the stock drops to $44.95 on the last Friday of the options period, the stock last trades at the $44.95 point. To quickly look at it you might think, “I might get assigned Joe’s stock and be forced to buy the stock for $45 when it is only worth 44.95.” However, looking at the numbers tells us another story. Joe bought the puts that you had sold for thirty-five cents, or $35 total for each put. If he assigned you the stock for $45, Joe will have to buy the stock on the open market at $44.95 to sell it to you for $45. Therefore, he might make five cents on the deal. However, he had bought the option for .35.
This is a net loss for Joe of .30 on the trade. In addition, since he did not have the stock to begin with, he will incur more commission fees while buying the stock. Therefore, Joe might lose money and over-all you might make money deal, even though the stock fell below the strike price. Again, see Rule #2 earlier in this chapter.
This is how you might make money with the above trade. You sold the put for thirty-five cents using the 45 strike price and were put to (assigned) at 45. Therefore, you have to buy the stock from Joe at $45 so you then immediately (on Monday morning) sell the stock on the open market for $44.95 and you lose a nickel, plus some more on commission fees, on this trade. However, even if you incur a commission cost of twenty cents per stock and option, you could still make ten to fifteen cents per option on the deal. Do not forget that even though you lost ten to twenty-five cents on the stock assignment, you originally took in thirty-five cents per share.
If you have bought an option, your brokerage will allow you to notify them that, even though your option position is “in the money” you may decide to not exercise your option. Generally, this is for the reason as stated above. The rules change, but usually all options will be exercised if the position is in the money by a premium is .25 or larger, unless notified otherwise.
The stock continues to drop
If you have sold a put for the 45 strike price and the underlying stock price had dropped below the strike price, two things have happened. You now have a position that has “intrinsic” value as well as “time” value. Refer to the rules section earlier in this chapter.
Some use the phrase, “You are underwater” for this situation. This means that you have allowed yourself to get into a losing position. Do not allow the current stock price to get below the strike price that you are using. Believe me, it can, and will be tempting. Assume that you opened the position with the stock price at least 20% higher than the 45 strike price you used. That means that the stock price just a few days before was around $56. Therefore, if you step back for a clear look, you might say to yourself, “Uh oh, I now have a position where the underlying stock has dropped approximately $11 within this month. Do I really want to keep this position open?” It would take a psychologist to explain all the various reasons why you will want to stick with this position. It can be very hard to cut a losing situation. One thought that might help is to look at the position as a new one in which you are thinking about investing. Would you open this position with the above prices? If the answer is no, then do not keep it open!
The left side, right side brain problem might rear its ugly head. You will look at the position, and both of your rules have been broken.
The premium has more than doubled.
The stock has dropped below the strike price you are using.
You might look at this and say, “It just can’t drop anymore.” Well, believe me it can, and probably will. Say the stock has now dropped to $41, which is four points below your strike ($4 intrinsic value plus some time value—let’s say .50 time value). Now, you have to close the position for $4.50, or a $4.10 loss on this position. If you had sold fifty of these puts, it would be a $20,500 loss.
5,000 x .40 = $2,000 initial profit
5,000 x 4.50 = -$22,500 to close the position, $20,500 net loss
In the year 2000 through 2002, I went through many of these situations and lost over a million dollars. Common sense would say, how could you have let these positions and the losses mount up so fast? Believe me, it can happen. When losses are flying all around you, you can lose your perspective and your objectivity.
My hope is that you can now recognize the many traps that await you and how to avoid them.
Summary of Chapter 14
The two main ways to avoid major losses in your account while trading options are:
1. If the premium doubles, close the position
2. If the underlying stock drops to the strike price, close the position.
These are the last-ditch stops. Do not hesitate to close a position that is deteriorating.
CHAPTER 15
WHY OPTION PREMIUMS CHANGE IN PRICE
This chapter deals with the factors that affect the way an option premium can change. The two main forces are the actual underlying stock price and the length of time left in the options life. These two major forces do not always work in the same way.
Example 1: It is the first day of new option period. You sell an option on ZZZ stock, which is trading at $50 when you open the position. You used the 40 strike price. You received twenty-five cents for a premium.
On the second day of this period, terrible unexpected news comes out and ZZZ drops $8 to $42. The premium goes up to $2.50. Therefore, the stock drops eight points and the options went up $2 because of the amount of time left in the position (twenty-seven days).
Example 2: You do the same trade as above, but ZZZ stays right at $50 all month. The premium drops to five cents. It is now the last Friday of the option period and at 11:30 AM, the same bad news as above comes out. ZZZ immediately drops $8 to $42. The premium might go up to twenty-five cents.
As you can see, the same news got a different response from the premium price. This is because of the length of time that was left in the option period. In Example #1, there were twenty-seven days left, and in Example #2, there were 4 ½ hours left.
Next, I will show you three different scenarios. Any combination of these could happen to a position in any given month. In the trading month that we use for our example, there will be four weeks of trading time. Some trading months will have five trading weeks. You should always be aware of the amount of time in each trading month. There is nothing that says the position has to be opened on the very first day of trading.
Use ZZZ stock and the front-month of August
You use all the filters that are listed in Chapter 13 to see that the stock falls within your guidelines.
1. The stock price is currently $50.
2. You determine a safe strike price by 50 – 20% = $40.
3. There are no earnings reported this period.
4. Always a good August history.
5. Analysts like the stock.
6. A reasonable PE.
7. You check the option chain, and there is a 40 strike price available with a premium of .25 (bid).
8. You find the “return factor”. By dividing the premium by the maintenance
The 10% rule is used so, 10% of 40 = 4 + .25 = 4.25
.25 premium divided by the 4.25 = 5.8% return on this trade.
You decide to use this stock as all filters are positive. On July 20th, you open a position of ten puts of ZZZ-TV (August
40 put). Deposited in your account is $250 (.25 X 1000 = $250)
First Scenario
ZZZ stock performs great as the stock rises seventy-five cents during the first week of trading. There are now only three weeks left in the trading month. Many traders on the “other side” of the trade can see that without the stock dropping, they had better salvage what they can. On Friday afternoon, the option premium drops to twenty cents, so now you can buy to close the position and you could pocket five cents if you wanted to.
During week two, ZZZ drops to $49.50 by Friday afternoon. Usually you will now find that even though the stock has dropped $1.25 during the past week, the evaporation of time far outweighs this. You also still have a 9.5 point cushion remaining. Now there are only two weeks left in the trading month. The option premium now falls to .15.