Options 101: Picking a Ripe Put-Sell Candidate

              

The Options 101 column introduces readers to the basics of options trading by exploring rudimentary concepts and terminology, and dissecting the risks and rewards of various strategies. Though this series is designed for option rookies, we hope seasoned options speculators can learn something, too.

In yesterday's edition of Options 101, we examined the ins, outs, pros and cons of selling puts. In today's column, we're going to bring this elementary option play to life by analyzing a theoretical put-sell on tech titan Apple Inc. (AAPL: sentiment, chart, options).

The principles of put selling

Before we dissect our hypothetical strategy, let's first review what we already know about writing puts. Selling a put obligates the investor to buy shares of the underlying stock at a predetermined price (strike) if the option is assigned. While put purchasers are typically bearish on the security, put sellers generally assume a neutral to bullish stance on the stock.

The most common objective for writing a put is to cash in on premium. If the written put expires worthless – meaning the underlying stock finishes at or above the put strike by options expiration – the seller can pocket the net credit received at initiation. This represents the most the trader can possibly make on the play.

On the flip side, losses can be quite substantial when writing a put, should the underlying stock fall beneath the strike price by expiration. However, assuming the shares fall to zero, the put seller's maximum risk is calculated by subtracting the initial net credit from the put strike.

(Don't forget to include any brokerage fees, margin requirements or commission costs.)

An Apple a day...

On to why we singled out AAPL for our hypothetical put-sell.... As we discussed in yesterday's column, investors should screen for potential put-sell candidates with some of the following criteria in mind:

• Don't write a put on a stock you wouldn't want in your portfolio, in case of assignment
• The stock should have some potential support levels in place, as an unanticipated decline could result in significant losses
• Search for puts with elevated implied volatility levels compared to the stock's historical volatility, as this configuration typically suggests the options are pricier than usual (meaning more premium for you)

Combing through AAPL's backdrop, the iPhone issue meets all of the aforementioned standards. For starters, owning shares of AAPL wouldn't necessarily be the worst thing in the world, considering the equity has outperformed the S&P 500 Index (SPX) by 11% during the past 60 trading sessions. On that same note, the stock has several potential layers of technical support in place, reducing the chances for a significant decline.

The most obvious support comes from AAPL's ascending 10-week moving average, which hasn't been breached on a weekly closing basis since early March. In addition, the security has more than 65,000 open put positions at the December 180 and 185 strikes, which could act as options-related support in the intermediate term.

Which brings us to our final catalyst for choosing AAPL as our theoretical put-write: implied volatility. The stock's December 180 put was last bid at $5.65, and currently harbors an implied volatility of 35.4%. Compared to AAPL's two-month historical volatility of only 27%, this option is relatively expensive at the moment.

With the framework for our put-sell firmly in place, let's examine the specifics of our hypothetical strategy.

The iStrategy

For our theoretical option play, we're opting to sell the AAPL December 180 put, which, as previously mentioned, was last bid at $5.65. Our primary objective is for the shares of AAPL to finish at or above the $180 level by options expiration on Friday, Dec. 18. In this best-case scenario, our 180-strike put would expire worthless, allowing us to pocket the initial credit of $5.65.

However, should the equity cascade past aforementioned support in the $180-$185 neighborhood, our losses could be quite substantial, depending on how far the stock declines. In order to avoid a loss on the play, we need the shares of APPL to remain above breakeven at the $174.35 (180 – $5.65) by options expiration.

Fast forwarding to early December, let's assume the shares of AAPL take an unexpected turn for the worse, backpedaling to the $165 level. In this instance, the put buyer on the other side of the aisle could put the option to us, obligating us to purchase 100 shares of AAPL for $180 apiece. In other words, considering the equity would be worth only $165 a share on the broad market, we'd have to buy the stock at a significant premium to fair value.

In conclusion

Before embarking on your put-writing journey, it's important to thoroughly screen your potential stock candidates. The ideal contender will be a stock that you wouldn't mind in your portfolio, has potential support levels in place, and harbors puts with elevated implied volatility levels. Also, put-selling novices should remember that time decay is the option seller's friend. In other words, selling out-of-the-money options may generate a smaller premium than writing their closer-to-the-money counterparts, but the risk of assignment is usually much less.

Finally, while the probability of success for this strategy makes it appealing, it's important to understand the potential risk/reward configuration. The put seller's maximum potential loss could be quite substantial, should the underlying stock take a significant turn in the red, while the most you can gain on the play is capped at the initial premium received.