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This is a level 2 question.
I am looking for a more conservative method of investing in options. I have heard that put selling might be such a method. Can you provide more information about it?
Selling out-of-the-money puts is designed to rival a stock-trading portfolio because it offers two methods for generating profits: collecting premium by selling an out-of-the money option and/or acquiring a blue-chip stock at a reduced price. The primary benefit of this strategy is a high winning percentage, although the profit per winning trade will be lower than more aggressive option strategies.
This strategy involves selling an out-of-the-money put on a stock that the investor would be willing to buy as their own if the stock took a temporary plunge. The majority of the time, however, the put will expire worthless, allowing the investor to pocket the premium and receive a 10-percent to 15-percent profit without ever having to buy the stock. While there is a margin requirement when selling puts, this commitment of funds might be compared to the outright purchase of the equivalent number of shares. Put selling takes advantage of the concept of time decay - the premium an option sells for declines as the option approaches expiration. Also known as time erosion, time decay allows the option seller to profit without having to correctly predict the future direction of a stock's movement, as long as it remains above a predetermined price. This factor benefits the put seller, while it hurts the more aggressive options buyer. Furthermore, if the price of the stock should drop below the put's strike price, put selling is a great way to acquire that stock at a lower price.
The profit for a put-selling trade is based on the margin required when the trade is initiated. The initial margin requirement for a put-sell trade is 20 percent of the underlying stock plus the credit received, less the amount the put is out of the money. For example, the margin for a 55 strike put that sold for 1.50 on a $57 stock would be $1,090 per contract [($57 per share x 0.2 x 100) + (1.5 x 100) - (2 x 100)]. This results in a profit return of 13.8 percent (150/1,090). Should the stock fall below the 55-strike level before expiration, the shares could be assigned at a price of $55 per share. In many instances, this too is a profitable conclusion, as the stock often rises higher within the first few weeks after acquisition.
Here are a few helpful hints for put sellers. (1) Do not focus simply on the higher option prices seen on high-volatility stocks. These premiums are high because the stock is expected to move significantly, which could force an assignment. (2) Do not become overly exposed to put-sell positions. In the event of a broad-market decline, you should be in position to afford the obligation of purchasing all of the shares covered by your sold puts. (3) While a put-selling strategy has a high winning percentage, realize that you will be assigned on occasion. Therefore, only sell puts on stocks that you would want to add to your portfolio. (4) It is advantageous to pick a put strike price that is near a major support level. If you are assigned, there would then be a good chance that you could benefit from a subsequent rebound from that support. (5) Choose options with one to three months until expiration, as these have more attractive premiums relative to the time until expiration. (6) To improve the odds of not getting assigned, go out another month and go deeper out of the money on your put. (7) Ultimately, the success of this or any options strategy depends on a successful approach for picking stocks. Look for strongly uptrending stocks that are relative-strength leaders and that have modest expectations. (8) Always remember that this is a strategy with a limited upside (the premium collected), while the risk will continue to increase as the stock declines.
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Question Level Key
Level One--Basic Jargon, Definitions, Basic Mechanics of Trading.
Level Two--Introductory Points, Practical Points and Simple Strategies
Level Three--More Advanced Strategies and Repairs
Level Four--Risk Management, Psychology, and How Best to Evaluate Things.
Level Five--High end questions concerning Portfolio Analysis, Managing a Portfolio
of Options, Option Pricing Models, and Nuances of Trading. Included could be a variety of
other topics.
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