Hello everyone, and welcome back to optionalpha.com.
This is Kirk, here again.
And in this video, we're going to talk about the short put option strategy.
So as always, we'll get right into it here.
So, we're going to first take a look at the market outlook as we always do when we look
at different option strategies here.
Now, as you know, the naked put write is also called a cash-secured put, in case you're
writing it in an IRA or a retirement portfolio.
But as a trader, you're really expecting a steady rise of the stock price during the
life of the option, and you consider the likelihood of a decline very remote.
Now, how conservative you get is something that we'll talk about later on in this video
tutorial.
But think about option selling and particularly, put option selling like selling stock insurance
on a stock.
The only real goal for writing an uncovered put or selling a naked put is to earn the
premium as income.
So, I'll use the analogy that I always use, and it's the analogy that was taught to me.
It's like selling insurance on a house, right?
If you own a house, or later on you might own a house, you're going to buy insurance
in case the house burns to the ground that the insurance company is going to pay big
time to help you rebuild that house.
Now, for that protection, you're going to pay the insurance company a premium every
single year.
And if your house never burns to the ground, then the insurance company keeps that premium,
right?
That's their income for the protection that they're giving you.
Well, selling a put is just like that for a house, right?
You sell insurance on a stock.
You protect investors from the strike price all the way to zero.
And for that risk, you take on some sort of premium as income.
So, how do we set this up?
These are very easy to setup actually.
It's just a single leg option.
So, you simply go into your broker platform and you initiate an order to sell a put to
open, you sell it right at the strike price and the expiration period that you desire.
So, you can sell these front month, meaning the next expiration period.
You can sell them close to the market, far away from the market.
Obviously, the closer you get in expiration period and the further away you get, then
it will change the premium that you receive because it changes the risk reward profile
of the option strategy.
So, like I said here, the more conservative you are, the further out of the money you
can sell the put option.
So, what's the risk with this particular option strategy?
While the maximum theoretical loss is limited, but it's very substantial.
So in theory, there is a limited loss.
The worst that can happen is for the stock price to fall all the way to zero.
In this case, the investor would be obligated to buy a worthless stock at a strike price.
So again, when we talk about option selling, we are actually on the obligation end of an
option.
So, if you're an option buyer, then you have a choice, you have an option.
If you're an option seller, (whether it's a call or a put) you're on the obligation
end, and it's up to the other party if they want you to exercise that obligation.
So, if the stock were to fall all the way to zero, then we'd still be obligated to buy
the stock at the 45 strike price which is where the option actually pivots in my particular
chart here.
So, we'd be buying a stock that's worthless at $45 a share.
You can see this is a very real threat for individual stocks, right?
Individual stocks overnight, can gap lower.
Do I dare even mention Netflix, Bear Stearns, Lehman Brothers, etc.
It is a very real risk.
But not so much for indexes and commodities which is why I tend to favor these on those,
because the S&P 500 index can never really go to zero.
It's made up of 500 individual stocks, so all 500 stocks would have to go to zero.
Commodities really could never go to zero, right?
They have some value in the marketplace like oil and gold and silver.
The profit potential (like we talked about earlier) is just the premium that you took
in during the sale of the put option, right?
So, just like an insurance company that gives you a policy to protect your house against
fire, you are only going to give them that premium for the entire year.
They don't ask for any more money if you negotiate a single premium.
So, just like that with option selling and put selling, the maximum gain is the premium
you took in.
So, the best case scenario is for the stock price to be anywhere above the strike price
at expiration.
In that case, the option expires worthless and you never have to do anything to close
the trade.
You just keep that money.
And that's where some commission savings really come into play.
So, when we talk about volatility, we are short in options.
So generally speaking, an increase in volatility would have a negative impact on this strategy,
everything else being equal.
Again, remember that volatility tends to boost the value of options, and since we want the
value of our option to go to zero by expiration, a big move in volatility can be harmful because
then, the stock can swing in bigger chunks and can swing outside of our profit target,
right?
So, we want low volatility, minimal movement in the underlying security or stock.
Remember that at the money options will have different volatility characteristics and will
behave much differently than out of the money.
If you sell an option right next to the market and right at the money, then that will behave
completely different than if you sell an option that say $20 or $30 away from the market.
When we get into time decay, time decay is actually one of our strongest assets when
we're talking about put selling.
So, the passage of time is really what creates the opportunity for the strategy and is therefore,
very positive for short puts.
Remember that we want the option to expire worthless, so every day that passes and we
can get some really good time decay on these strategies, is money in our pocket.
So, the closer we get to expiration without the stock moving beyond the strike price,
the better.
As expiration approaches, the option move towards its intrinsic value.
So, as it becomes an out of the money put, that intrinsic value is zero.
So, if we never have to pay any money on our insurance contract, (again, going back to
our insurance analogy) then we get to keep all that money.
So, every day that we get closer to the expiration day of that insurance contract is better for
us.
When we talk about breakeven points, (again, this is very easy to calculate with this particular
strategy) it breaks even if the stock price is equal to the strike price minus the initial
put received.
Anything above this level at expiration is in towards your maximum profit.
So again, let's say we have a 45 strike put here that we sold.
So, we take the strike price, we subtract the premium that we received, and that is
our breakeven price, right?
So, we got the premium, and so, we have to move that down the scale to see where our
breakeven price is.
Again, very easy to calculate with short puts.
Let's look at an example just to really drive home the point.
So, we have a stock price that's trading at 50 right here on our chart.
We're going to sell one 45 put and take in a credit or a premium of $200.
Now, just quickly, let's flip this around and say we were going to buy this 45 put option.
We'd be outlaying that $200 to buy the option.
But since we're on the other end of the trade, we're selling that option for a $200 credit.
Immediately, that comes right to your account.
So, you get a $200 credit.
Now, the maximum loss again, is practically unlimited to the downside.
Again, if you choose a stock that's highly volatile and it just absolutely falls to pieces,
then you do have a huge loss.
Now, if you do this on an index, (for example) then your losses are much, much more capped
in theory because they're not going to go to the downside.
An index can never close all the way down at zero.
It's made up of securities.
Same thing with commodities like gold, oil, silver.
Your maximum profit again is your $200.
So again, it's just the premium that you took in.
So, if you took in $500, your maximum profit would be $500, whatever the case is.
Now, you can actually buy this back later on during the cycle.
You can buy another option back and create some sort of profit.
So, let's say that you actually sold it for $200, and further on down the road, you actually
see that this has decayed down to a value of $100.
So, you could go back in and buy one 45 strike put, (again, reversing your trade) whereas
you are short one put option, you now want to become even or neutral, so you create a
reversing order and buy that put back, and you pay $100.
Because remember, the value right now is $100.
So, you're going to sell it at $200 and buy back later at $100.
Again, this is a good opportunity to close out the trade early and take in some really
good gains.
Some of my tips and tricks regarding put selling and naked put selling.
Short puts are really the bread-and-butter of my personal options trading plan, and have
been for years, and literally years when I talk about this, six to seven years now.
They sound really dangerous on the outside, but in reality, option buying is much, much
more dangerous.
So, what I do is I sell deep out of the money puts.
I sell puts that are very far from the market, 20%, 30% away with historical probabilities
of expiring worthless between 90% and 95%.
And you can actually get these percentages right on your broker platform.
I avoid selling close to the market.
Again, the closer I get to the market, I do get more premium, but it also becomes more
risky.
And if done properly, put selling can be a non-directional strategy for monthly income.
Again, I've been doing it for years.
You can check my performance.
I'm 100% open and honest with all the trading that I do here on the website and this is
my bread-and-butter strategy.
And it is one of the basic building blocks of other strategies that I'll talk about in
different videos.
So as always, I hope you guys really enjoyed this video.
And thanks for watching!
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