This strategy offers profitable returns on unleveraged equity in a highly volatile market; however, it is an advanced trading strategy generally not advised for novice investors. Learn how seasoned investors use options to generate returns in an environment when other investors are losing money. It helps to review what causes stock sell-offs first and then learn about trading sell to open put options.
Panic After the Peak
Many investors feel uneasy when the stock market peaks and begins an inevitable downward trend. If the trend continues, many investors panic. As the trend continues, investors sell off their shares quickly in attempts to avoid further drops in stock prices—and the resulting hit to their portfolio’s value. For instance, at the close of the markets on October 14, 2008, shares of Tiffany & Co. were selling at $29.09 each, down from a high of $57.32 before the crash on Wall Street. Investors panicked, thinking the retail environment would fall apart and that high-end jewelry was going to be one of the first markets to collapse because consumers weren’t going to buy expensive items when they couldn’t even pay their mortgages. You could have purchased 1,000 shares of Tiffany’s stock by spending $29,090 (plus $10 for commission) and use the $29,100 to buy the stock at the October 14, 2008 market price of $29.09. However, a sell to open put option might have further reduced the price you’d have paid for the stock.
What Is a Sell to Open Put Option?
Stock options are choices that investors sell to each other. Investors buy or sell options to have a choice to buy or sell a stock at an agreed-upon price—called the “strike price.” Buying a put option gives the purchaser the choice to force the option seller to buy the stock. In a market where prices are falling, the buyer tries to make strike prices higher than the market price they anticipate because they try to mitigate their losses. A short position is where you have borrowed a stock from a broker, and you try to sell it. You create a put option on a short position, and sell to open the position. This makes a sell to open put option. A buyer can purchase the option, which you then plan to buy back at a later time (sell to open, buy to close).
How Do You Trade a Sell to Open Put Option?
For the strategy to work, you must sell the option at a higher price and then buy the stock later, at a lower price from your broker and keep the profit, assuming the market goes down. The options buyer isn’t obligated to exercise the right to sell the stock, but when the stock price keeps dropping, the option provides the investor with the ability to sell at a set price. This protects investors by letting them get out of their stock position before it loses too much value. For example, suppose an investor were willing to pay for an “insurance premium" of $5.80 per share if the option seller (you) were to agree to buy the stock if the price were to fall to $20.00 per share. You could create this insurance policy by selling (also called “writing”) a put option contract that covers 100 shares. By writing this contract, you would agree to sell another investor the right to force you to buy their shares at $20.00 each. They can execute the option any time they choose, between the time of writing and the close of trading, on the day you’ve selected for this put option to expire. In exchange for writing this “insurance policy” that protects the investor from a significant drop in the stock’s price, he pays you $5.80 per share. This is money you keep.
Using the Sell to Open Put Option
Several scenarios might play out when using a sell to open put option. Here are two, using the Tiffany & Co. example.
Buyer Doesn’t Execute the Option
Suppose you were to take the $29,100 and agreed to write insurance for another investor or “sell to open” some put options on Tiffany & Co. shares. You set an expiration date of the close of trading on Friday one year from today, at a $20.00 strike price. You contact your broker and place a trade for 20 put option contracts. Each put option contract represents “insurance” for 100 stock shares, so 20 contracts cover a total of 2,000 shares of Tiffany & Co. stock. The moment the trade executes, you’ll earn $11,600 (2,000 x $5.80) of cash for your options, minus a broker commission. If the stock price doesn’t fall below the strike price, you can add the $11,600 to the $29,100 cash you were previously going to invest in Tiffany & Co. common stock, for a total of $40,700. Because of the put options you sold, you have a $40,000 total potential commitment to your put option buyer, minus $11,600 in cash received from him, equaling $28,400 remaining potential capital you’d need to come up with to cover the stock purchase price if the options were exercised. Since you could have spent $29,100 buying 1,000 shares of Tiffany & Co. stock anyway, you’d be fine with this outcome. You could immediately take your $40,700 and invest it in United States Treasury Bills or other cash equivalents of comparable quality that generate some low-risk interest income. This cash would there as a reserve until the put option contracts expire. In this scenario, the company’s stock stays strong. The buyer never exercises their options, making them expire. You would keep the money the buyer paid you for the “insurance premium.”
If the Buyer Executes the Option
Suppose your options buyer gets anxious at Tiffany & Co.’s dropping stock price and exercises the options, and you now have to buy 2,000 shares of Tiffany & Co. stock from him at $20 per share for a total cost of $40,000. Remember, however, that only $28,400 of the money was your original capital. because the buyer paid you $11,600 to write the “insurance.” Your effective cost basis on each share would become only $14.20 ($20 strike - $5.80 premium = $14.20 net cost per share). Recall that you were initially considering buying 1,000 shares of Tiffany & Co. stock outright at $29.10 per share. Had you done that, you’d now have some significant unrealized losses on the stock. Instead, by using options, you’d own 2,000 shares at a net cost of $14.20 per share vs. $29.10 per share.
What Are the Risks?
If the company were to go bankrupt, you’d lose the same as if you’d bought the stock outright. If you were to anticipate the market incorrectly, you could wipe out your investment accounts in one transaction. Sellers who are just learning how to sell options can become intoxicated by the large cash receipts deposited into their account from “insurance premium” payments. Much of the time, they don’t realize the total amount they need to deposit in the event that all of the put options they sold were exercised. A trader might have a substantial enough margin account to buy these shares anyway, but that could evaporate in the event of another round of widespread market panic. In that case, you would find yourself receiving a margin call where your broker would require you to replenish your investment account while you’re experiencing losses—many investors have lost everything and gone into debt to fund their margins when brokers have made margin calls.
