If you’re bullish on a major mining company, like Arizona-based Freeport-McMoRan Copper & Gold (NYSE: FCX), the first thought that comes to mind is to simply buy the stock. Though that can be a good idea if the stock moves up right away, there might be a better choice for a stock like FCX that trades in a range or moves up slowly. A short put is an option trade that might be new to a lot of investors, but it can be a useful strategy whenever you’re thinking about buying stock.
The idea is, if the stock drops and the put is in the money at expiration (where the stock price is lower than the strike price of the put), the short put is assigned, and the investor buys a long stock position at the strike price of the put. The cost of buying the stock this way can be less than buying the stock outright. With FCX at $102, if I sell the 100 strike put for $6 and FCX is lower than $100 at the expiration of the option, my cost basis on the stock would be $94 ($100 minus $6).
A short-put position is established by selling a put option that you don’t own. You may have heard that selling options short, without any protection, is a dangerous thing to do. That can be true, but selling naked calls on a stock, which can theoretically go up indefinitely, has the potential of unlimited loss—that’s why most investors should stay away from them. While a naked short put has risk, the risk is similar to buying stock.
What’s the maximum risk on a short put? If the stock goes to $0, you would lose the value of the put’s strike price, minus what you sold the put for. That is the same as if you bought the stock. Either way—short put or long stock—the potential loss is the same. Another risk of a short put is that if the stock moves up a great deal very quickly, the short put has a maximum gain limited to the price you sell it for. The long-stock position can provide a much greater profit.
So what’s the advantage of selling a put? First, selling an out-of-the-money short put will have positive time decay. That means that even if the stock doesn’t move up, time passing whittles away at the value of that put—and that’s good if you’re short it. If you are long-stock and the stock doesn’t move up, you don’t make anything. Another advantage of shorting a put is that you don’t spend any cash to do it. Shorting a put actually increases the cash in your account, so you don’t lose interest on the cash in your account like you would if you bought the stock. Yes, there is a margin requirement on the short put (about 20% of the value of the stock in a margin account, or the value of the strike price in an IRA), but that means that you can’t use the cash set aside to cover the margin of the put. It doesn’t mean that you stop earning interest on it. Offsetting the cash advantage is the fact that, if the stock pays a dividend, you are not entitled to receive it if you’re short the put.
So if you want to short a put, which expiration and which strike price do you choose? That depends on how much you want to buy the stock. Do you want to sell a put and hope it expires worthless so you can sell another in the next expiration and collect the time decay? Or do you want a higher probability of being assigned on the short put at expiration so you can get the long-stock position? Generally speaking, you want to sell a put that has about one or two months to expiration. That gives you a good balance of a high rate of time decay with a reasonable value in the option. For example, with FCX at $102, the 95 strike put with 10 days to expiration is 95 cents, while the 95 strike put with 40 days to expiration is $4. Even though the option with 10 days to expiration has the higher rate of time decay per day, the option has much less value to capture from that time decay (a maximum of $95). The time decay of the $4 option starts out lower, but it gets higher as the option gets closer to expiration, and it can capture much more value ($400). If you want a higher possibility of buying the stock at the strike price, you could sell at the money put (the put whose strike is closest to the stock price) and collect a higher option premium. With FCX at $102 and 40 days to expiration, that would be the 100 strike put with a price of $6. That option would have a roughly 50% probability of expiring in the money. But you could also sell a put that is one or two strike prices away from the stock price, and although it would have a lower price than the at-the-money put, it would have about a 65% probability of expiring worthless.
For example, that 95 strike put with 40 days to expiration is $4, and it has a probability of expiring in the money of about 36%. Even though you collect less money for selling that 95 strike put and it has a lower likelihood of being in the money to give you that long-stock position, that might be the put to sell if you want it to expire worthless. It will let you sell another put in the next expiration cycle and continue to earn time decay on a stock that doesn’t move up very much. Also, the stock can drop a bit and the short out-of-the-money put can still make you money—as long as the stock is higher than the strike price at expiration. So, when you add this technique to your arsenal of trading strategies, think “one month out, one strike away” to narrow your choices of which put to short.
— By Tom Preston
Tom Preston is a founding partner of thinkorswim and the chief
architect of its trading platform. He holds multiple degrees, including
an M.B.A in finance and statistics from the University
of Chicago.
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