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Put Writing - A Simple Approach
 

Put writing (selling) is designed to complement a conservative investing portfolio because it offers two different methods for generating profits with relatively low risk.

1) Earning consistent (small) returns with portfolio collateral by selling out-of-the- money options.

2) The sale of in-the-money puts to acquire stocks at a reduced price, which are eventually sold for a gain.

The basic strategy involves selling a put against cash or other collateral held in a brokerage account. According to the terms of a put contract, a put writer is obligated to purchase an equivalent number of underlying shares at the sold strike price if assigned an exercise notice on the written contract. The purpose of the collateral is to assure that money is available to purchase the underlying stock should the put be physically assigned to the investor's account. However, if the share value is above the sold strike price at expiration, the put will expire worthless and the option premium retained by the seller constitutes a profit.

 
Selling "Premium" for Profit
 

Writing puts for monthly income generally involves selling "out-of-the-money" options on a stock that the investor expects to finish above the sold strike price. With careful selection of the underlying issue, most of the sold puts will expire worthless, allowing the investor to receive a favorable profit without ever having to buy the underlying stock. Of course, there is still the mandatory margin requirement but this commitment of collateral funds is almost always less costly than the outright purchase of an equivalent number of shares. For example, the margin necessary for a long stock purchase is typically 50%, whereas the initial collateral requirement for a cash-secured put is often less than 25% of the value of the underlying issue. This amount can vary due to prices changes in the underlying issue, but the ratio for margin maintenance is similar. Additional information on these requirements can be found here:

http://www.cboe.com/LearnCenter/pdf/MarginManual2000.pdf

Despite the high probability of success with this strategy, losses can (and do) occur. The most common causes of a failed position are unexpected news or events, which lead to a sharp decline in the price of the underlying stock. Bearing this fact in mind, it is crucial for investors to sell puts only when they would be happy owning shares of the underlying stock, because assignment is possible at any time before the put expires.

Buying Stock at a Discount
 

An investor who is interested in buying a stock may also consider selling a cash-secured put as a means of acquiring the issue. Usually, when a person wants to buy a stock at a specific price, he will use some type of "limit" order. The problem is, after the initial order is placed, the stock will not be purchased until it trades at or below the limit price. Instead of waiting for that movement to occur, he could simply write an in-the-money put. A specific amount (based on the bid price of the option) of money will be paid to his account for the obligation to buy the stock. If the stock price remains below the strike price of the sold put at expiration, the option will be assigned and the investor will be obligated to purchase the stock. The basis in the stock is easily calculated -- it is simply the strike price of the option minus the credit received in the initial transaction. More importantly, it is necessary for the investor to decide whether this net cost (for each share) is acceptable prior to initiating the trade.

The secret to success with this approach is balancing the probability of assignment against the net cost of the stock. Obviously, an investor who wants to own a particular issue can simply purchase it outright in the open market, so there must be an particular advantage to the sale of a put before the strategy becomes viable. This is where a lesser-known aspect of option pricing can tip the scales in favor of a short put. Without going into extensive detail, suffice it to say the greatest amount of time-value (or excess premium) in the value of an option exists in the strike price(s) closest to current value of the underlying stock. Therefore, investors who are interested in stock ownership should focus on selling strike prices equal to, or slightly below, the current price of the stock, where there is favorable profit potential and, at the same time, a reasonable expectation of owning the issue. This technique is commonly used by fund managers, as well as large corporations, because it pays them for assuming the obligation to buy a particular stock that they intend to eventually add to their portfolios.

 
The PPP Approach
 

Our approach with the PPP Portfolio involves the sale of deep-out-of-the-money options, where the probability of a successful outcome is very high. Generally, we try to achieve a 3-5% monthly profit (based on the minimum collateral/margin requirements) with at least 10-15% downside protection in the overall cost basis of the position. That can be a difficult task when the market is in a bearish trend but there are always a few candidates with favorable technical indications, regardless of the current outlook. At the same time, if we don't have confidence in what we have to offer, it won't be listed, and that is the overriding measure of any candidate we include in the portfolio.

Strategy Specifics: Cash-Secured Put
 

The strategy of writing cash-secured puts consists of one transaction; the sale of put options on a specific issue or index. The put writer retains the money earned from the sale of the puts, regardless of how much the stock increases or decreases in price. If the options are assigned, the put writer is obligated to purchase an equivalent amount of underlying shares at the sold (short) strike price. Of course, the funds received from the sale of the put will partially offset the cost of buying the stock, and will hopefully result in a net purchase price below the current market value. But, if the share price of the underlying issue falls significantly, there will be a loss (unrealized until the stock is sold) in the position. The only positive aspect at that point is the ability to sell the shares at a higher price in the future.

 
Risk/reward calculations:
 

Maximum profit = the initial credit received

Maximum risk = the sold (put) strike price - the initial credit received

Break-even point = the sold (put) strike price - the initial credit received

(Note: The final price of the stock determines the actual profit when that price is below the sold put strike but above the break-even/cost-basis.)

Return On Investment = credit received / margin (collateral) requirement

 
Margin (collateral) formulas:
 

The margin requirement per contract is the greater of:

The credit received plus 40% of the underlying stock price, less the out-of-the-money amount;

(0.40 * Stock Price + Credit - (Stock Price - Strike Price))

- or -

The credit received plus 20% of the underlying stock price;

(0.20 * Stock Price + Credit)

The second formula generally applies when the sold strike price is considerably lower than the current stock price (deep-out-of-the-money), thus it is the more common formula for the positions in the PPP Portfolio.

 
Strategy Advantages
 

Most option strategies take advantage of leverage by enabling a trader to achieve large profits on relatively small moves in the underlying issue. In return for leverage, option buyers sacrifice time -- their predictions must be correct AND timely because an option's "premium" (or time value) erodes each day it is in existence. The problem with this approach is it provides very little margin for error and that is why few retail option buyers make money on a consistent basis. In contrast, traders who sell "premium" have time on their side. Each passing day has a positive effect on a short option position. In addition, a cash-secured put is not dependent on directional movement by the underlying issue to achieve profitability. The only requirement is that the share value of the stock remain above a specific price for given period.

Position Management
 

Similar to all option trading techniques, cash-secured puts need to have some type of exit point in case the market, stock, and/or sector or industry group moves in the opposite direction from that which is expected. In fact, learning when to initiate a closing transaction is probably the most important aspect of becoming a successful trader. Also, the success of a high probability/low profit strategy such as writing cash-secured puts is keeping losses at a minimum. There are never any big winners to offset the big losers, so there simply can't be any big losers. Obviously, a gapping issue will occasionally wipe out a portion of previous gains and there is nothing you can do about it. At the same time, you must manage the remaining positions effectively or there will be no profits to offset the (rare) catastrophic losers.

A put writer has many different alternatives when the underlying issue moves below the sold strike price before option expiration but in most cases, the appropriate action should be taken prior to that event, when the issue experiences a technical change in character such as "breaking-out" of a trading range or closing below a moving average. Most methods for taking profits and preventing losses, as well as making adjustments or rolling down and out to new positions, fit into one of two categories: a pre-arranged target profit or loss limit; or a technical exit based on the chart indications of the issue. The first technique, using a mechanical or mental closing stop to terminate a play or initiate a roll-out, is simple as long as you adhere to the initially established limits. The alternative method, a technicals-based exit, is more difficult. However, there are many different indicators available to establish an acceptable exit point; moving averages, trend-lines, and previous highs/lows, and with this type of loss-limiting system, you exit the play after a violation of a pre-determined level. In any case, the closing trade or adjustment should be based on the existing market, sector, and industry group conditions, as well as the current outlook for the underlying issue and the ratio of potential gain to additional risk.

One outstanding principle that new investors fail to adhere to is the need to outline a basic exit strategy, before initiating any position, to eliminate emotional decisions. This plan must be simple enough to implement while monitoring a portfolio of plays in a volatile market. In addition, these exit/adjustment rules should apply across a range of situations and be designed to compensate for one's weaknesses and inadequacies. Also, to be effective in the long term, they must be formulated to help maintain discipline on a general basis and at the same time, offer a timely memory aid for difficult situations. Using this type of system addresses a number of problems, but the most significant obstacle it eliminates is the need for "judgment under fire." In short, a sound exit strategy will help you avoid exposing your portfolio to excessive losses and that's important because the science of successful trading is far less dependent on making profits, but rather on avoiding undue outflows.

 
Specific Exit/Adjustment Strategies
 

Selling cash-secured puts is a popular strategy among conservative investors and there are a few ways to limit potential losses or even capitalize on a reversal (or transition) to a new trend in the underlying issue. In the case of short puts, there are three common methods to exit or cover a losing position. The first alternative is to simply buy back the sold options at a debit and register the loss. Second, you can use a popular exit technique among day-traders; covering (by shorting the stock) the sold options as the stock moves through the short strike. This is a great method for "bailing out" on an issue in which the trend or technical character has changed significantly due to news or events, but you must be prepared to repurchase the stock in the event of a recovery. Another strategy is to "roll-out" of the position to longer-term options. This approach works best when the price of the underlying issue is near the sold option strike, but has not endured a significant change in (technical) character. To initiate this strategy, the (short) puts are repurchased and new puts are sold with a lower strike and/or a more-distant expiration, in the best possible combination that will achieve a credit in the trade. The most optimum adjustment would use the same strikes in the closest available month, so that you would be selling the highest relative premium without committing to a long-term position. Obviously, this outcome is not always possible, and I caution against using this technique on all but the most high quality (blue-chip) issues, as you can quickly run out of downside margin if the stock declines further.

One thought I would add concerning position adjustments (as opposed to position exits) is that in almost every case, the decision you make about a specific trade should be based on your analysis of the underlying issue and your forecast for its future movement. That assessment is then factored into the risk-reward outlook for the strategy and the specific position you are considering. Of course, that's a very subjective task and the best advice I have seen on the subject is: If conditions dictate that a new position in the issue is viable, based on the fundamental/technical indications, the size of the premium/credit, and your personal criteria regarding the profit/loss outlook, then it should be considered as a candidate along with any other potential plays currently being evaluated.

The great thing about option trading is that once you become experienced with the various adjustment techniques, you can turn many losing plays into winning ones with the effective use of stops and by rolling out-of/in-to new positions when the stock moves against you. When you do lose, at least you have reduced your losses by leveraging against another position. In all cases where an attempt to recover a losing position is made, you must be prepared for further draw-downs and have thorough knowledge of the strategy. Also, as with any trading technique, it must be evaluated for portfolio suitability and reviewed with regard to your personal approach and trading style.

Additional Information
 
The best books on the subject of "premium-selling" techniques are the original bibles of option trading: "Option Volatility & Pricing: Advanced Trading Strategies and Techniques" by Sheldon Natenberg, and "Options As A Strategic Investment" by Lawrence G. McMillan (both available in your local library).
FAQs
 

1) What is the experience level and capital requirement for trading this portfolio?

Investors who participate in the PPP Portfolio should have a fundamental knowledge of common option trading strategies and position adjustment techniques. Traders who write uncovered options should also have a thorough understanding of margin maintenance requirements and the potential obligations that the sale of an uncovered option entails. More information on margin is available here:

http://www.cboe.com/tradtool/marginmanual2000.pdf

In addition, all derivatives traders are required to read the Characteristics and Risks of Standardized Options before opening a position. Here is a link to that document:

CharacteristicsandRisksofStandardizedOptions.pdf

As far as capital requirements, the objectives of the PPP Portfolio can generally be achieved with a $10,000 account balance. However, large unexpected swings in the market (or a specific issue) can significantly increase the margin maintenance requirement. When this occurs, it may be necessary to secure additional funds to manage the portfolio efficiently. Traders who are not certain they will be sufficiently capitalized should make the necessary adjustments during position selection and when choosing the number of contracts for a specific issue.

Selling "premium" can be a very aggressive strategy, especially when you have no desire to own the underlying issue. A similar technique that provides catastrophic downside protection, as well as consistent margin requirements, is the put-credit spread. Investors who can not tolerate the maximum risk in a cash-secured put should consider this strategy; it is often a viable alternative for bullish issues with similar characteristics.

2) How often are new plays published and when is the portfolio updated?

New positions are listed on a weekly basis, generally on Sunday afternoon, as long as market conditions are favorable. Additional candidates may be published during the week (after the major exchanges close) to supplement the portfolio. Updates on individual issues will be made, whenever possible, in a timely manner. However, traders are encouraged to maintain stop-loss orders on all positions to limit potential draw-downs from unexpected news or events.

3) How do you choose the positions in the PPP portfolio -- what is your primary selection criteria?

In choosing the portfolio candidates, we generally look for positions that provide a minimum potential profit of 3-4% per month (annualized) with downside protection of at least 10%. Using deep-out-of-the-money puts, that allows us to focus on positions with a very high probability of profit, sometimes as high as 90%, which corresponds roughly to the 2nd standard deviation of a normal distribution. (For those of you who like statistics, the market almost always remains within the 2nd standard deviation of a normal distribution). Obviously, it would be great if every published position were in this category but since that isn't possible, the best course of action is to choose trades that offer a favorable balance between probability of profit and potential downside risk. That's the real challenge in any form of trading and although we try to identify only candidates that will help the portfolio achieve its specified goals, not every play is a winner so the main objective is to limit losses and close losing positions before they become costly, preserving your trading capital for the next success.

4). What is the "target" entry price and why do you list that price for each position?

Many of our subscribers are less experienced traders that need simple, easy to understand strategies and one of the first skills new participants must learn is to execute a favorable opening trade. A good technique for initiating an option position is to place the order as a "limit" order. Thus, when a new position is listed, we include a suggested "target" to help traders determine the appropriate price for the order. This is simply a recommended entry point; just an opinion of what a trader might expect to receive for the sale of the option. It should be a reasonable price to initiate the play even with small changes in the underlying stock. The "target" is often less than the quoted BID price (try to avoid paying "market" price for option orders!) and occasionally, you can add $0.05-$0.10 to the initial credit when opening a new option position. Of course, the success of this approach varies, depending on the price of the options, whether they are ITM or OTM, the time value remaining, the volatility of the stock, etc. In addition, you may need to adjust this target based on the activity of the underlying issue, the trading volume of its options or the implied volatility of the series being traded.

5). How do we know when to exit a position?

Cash-secured puts, as well as all option trading techniques, need to have some type of position closing mechanism in case the market, stock, and/or sector moves in the opposite direction from that which is expected. Most methods for taking profits and preventing losses, as well as making adjustments or rolling up/down to new positions, fit into one of two categories: a pre-arranged target profit or loss limit; or an exit trade based on the historic prices/technical character of the underlying issue. The easiest system for directional, option-based strategies involves a mechanical or mental stop to close the position (or initiate a "roll-out" to a new play). Technical analysis; moving averages, trend-lines, and previous highs/lows, is generally used to establish the exit or "stop" point and with this type of loss-limiting system, you simply close the spread after the underlying stock violates the pre-determined level. If you choose to adjust or roll forward into a new position, always consider the existing market, sector, and industry group conditions, as well as the current (technical) outlook for the underlying issue and the ratio of potential gain to additional risk. More information on position adjustment techniques is available in the strategy tutorial here: http://www.optioninvestor.com/page/oin/cm/tutorial/

6). Do you provide portfolio data for "auto-trading" services?

No, not at this time. However there are plans to offer the service at a later date. More on this subject will be published when it becomes available.

 










 
 


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