The Nuts and Bolts of Alternative Option Trading
- Written by Carley Garner
Short Put Option
Sell an Out-of-the-money Put
When to Sell Put Options?
- If you believe the market is going up (bullish)
- The strength of your belief determines what strike prices you look to sell
- Sell out-of-the-money options (lower strike prices). If you believe prices are not going down
- Sell at-the-money option (at current price). If you strongly believe prices are not going down (this is not a recommended strategy)
Short Put Option Profit Profile
- Your profit potential is limited to premium collected minus commissions
- The reverse break even at expiration is equal to the strike price minus the premium collected
- Reverse Break Even = Strike Price - Premium Collected
- Maximum profit occurs if the market is above the strike price at expiration
What is at Stake?
- Exposes trader to unlimited risk; thus, these positions need to be watched closely
- Your losses increase if the market drops faster (increased volatility) than the time decay erodes the option value
- The market trading below the reverse breakeven point is equal to being long the futures contract.
- At expiration your losses increase by one point for each point market is below the reverse breakeven
Short Put Option Trading Example
In the last week of June 2006, the Euro had just completed a 61.8% retracement to create a good opportunity for put selling. Remember, premium collection works best when you are selling against the wave not with the wave. For example, you wouldn’t want to sell a put option as the market is rallying.
According to Black and Scholes theoretical option pricing, a trader could have sold a September 124.00 put for 90 points or $1125 before transaction costs. Thus, $1085, assuming a $40 commission rate, is the maximum profit on the trade and occurs if the market is trading above 124 at the time of option expiration.
The reverse break even on this trade would be 123.10 (124.00 - .90) providing the market plenty of breathing room. Anything above this point returns a profit; any point below is like being long a futures contract.