Sell puts, then write calls, then sell puts…

Put selling may appear to be an exotic option trade, but in fact, it is almost identical with the very commonplace strategy of buying stock.


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Robert continues (before the video was published):

I understand that the subject is really complex and there are no easy answers. I feel I need to add a bit of explanation.

About two years ago I read a book about selling naked puts and covered calls, the rules were simple. Sell naked puts; they should expire worthless at least every other time. Once assigned, start selling covered calls, the same as with puts, at least every other time they should expire worthless. If one does it many times the effective price one paid for the stock should eventually go to zero.

Today I do not think it is so easy. 2008 crash was not so long time ago, I heard about people selling naked puts and caught by surprise then. I would like to sell naked puts myself but I am not gonna do it without knowing what kind of hedging can protect me, did it once not knowing how to manage trade, it really hurt.

I am looking forward reading your posts regarding this subject.

Robert,

It’s remarkable to me that such a simple idea can not only be proposed by someone who is supposed to be teaching people to use options, but that such statements are allowed to go unchallenged.

It is true that when things work according to plan, selling puts – until one is assigned an exercise notice – and then writing covered calls – is a reasonable sounding plan that reduces the cost basis for the stock every time an option is sold.

There are two serious flaws with this plan, plus minor ones as well.

  • If short puts and the market tumbles, the trader is going to own stock at a price much lower than the original purchase price (put strike, less premium collected)
  • If you own stock and it soars, resulting in selling the shares, what next? Sell puts again at this now very elevated stock price? That does seem to be an attractive time to be selling puts.

Locking in a loss

Let’s say you bought XYZ shares at 40 when assigned an exercise notice on some Dec 40 puts that you sold. When the stock is 39, it’s no problem to write the Jan or Feb 40 calls to generate income and hope that the stock again moves above 40.

However, what do YOU do (not what does the average trader do) when the stock is priced at $34/share? If you try to write the 40 calls, allowing for the possibility of eventually earning a profit on the original trade – then the premium collected is going to be small and to ever come out ahead, you are going to have to write 40 calls for a long time, or see the stock move above that strike price. It’s very difficult to write calls and collect such a tiny premium. Most traders would rather not own that stock under these conditions.

There is the (intelligent alternative) of writing Jan or Feb 35 calls. The obvious benefit is being able to collect a premium worth collecting. If the options expire and you have not been assigned an exercise notice, you are no longer in such bad shape (from the point of view of trying to eke out a profit on original trade). NOTE: I suggest ignoring the original trade and concentrating on the position you own now. But, for most people that is an unacceptable idea.

Nevertheless, most traders refuse to make the best possible trade available at the time (write those 35s) and can only think that if assigned on the Feb 35 call, it would lock in a loss. That is bad thinking.

The trade has already incurred a loss, and the best you can do is to stop hoping for a miracle and trade what you see. That means selling the 35 calls with the expectation of earning some cash over the next month. If the trader is locked into the mindset that he/she must sell 40’s, that is not going to produce a good long-term strategy.

Robert – if you want to try this methodology, keep in mind that every month (or two) is a new trade. You are not forced to keep the shares if assigned. You are allowed to pick a better stock (one that you believe will achieve better results in the future. Don’t think abut moving the cost basis to zero. Thing about growing the size of your account.

One of the minor problems with this plan

Most traders begin by writing a put that is OTM. the goal is to see the options expire worthless and selling OTM options makes that far more likely. Thus, selling OTM puts becomes the game. Until assigned. Then suddenly the strategy changes. Why? Because that trader is trained to write OTM options and thus, sells OTM calls.

Because we know that selling colvered XYX Nov 50 call produces the same financial results as selling the Nov 50 puts, and if our initial strategy is to sell OTM puts, that strategy should not change when we are assigned an exercise notice and thus, own stock. If the stock is has moved to 48 (we were short Nov 50 puts), the tendency is to write Dec 40 calls for two reasons. First they are OTM (per our training) plus they provide an opportunity to recover the loss and come out with a profit.

However, if we think clearly, and if we understand that our trade strategy is to write OTM puts, then we should be writing the Dec 45 call, because we would surely be selling the Dec 45 put (and not the ITM Dec 50 put) if we were making our first trade in this stock. It’s a good idea to be consistent. But I know that there are very few, if any, traders who would consider making that trade. Selling the 50’s would be an almost universal choice for them. Always looking for the ‘get back to even and recover the loss’ trade. Never mind that this is a strategy change. Getting back lost money comes first when the trader adopts the strategy of selling puts until assigned, and then selling calls until assigned and then selling puts…

Hedging

The most important hedge comes first: Sell an appropriate number puts. If you would be comfortable owning X hundred shares, then sell X puts and not one single put more than that.

The other important aspect of hedging this type of trade is accepting the fact that at some point you will want to exit because the stock is falling too far. Put selling may appear to be an exotic option trade, but in fact, it is almost identical with the very commonplace strategy of buying stock. I get that you want to know how to manage risk. But let me ask a question: If you were buying 500 shares instead of selling five naked puts, would you be as worried about risk management? Would you feel that you need some special strategy to hedge? I doubt it. You would probably set a stop loss and not worry about it any more than that.

There is something about trading options that makes people believe the trades are very risky. Robert – the one thing that does make the sale of naked puts extra risky is that people believe they will expire worthless and thus, they sell too many. That’s what you should remember: SIZE KILLS.

Yes, we are trading options, but there is no need to be afraid of them. Robert: I’m trying to encourage you by saying that this is like trading long stock, and I hope you are comfortable doing that (even if you never do it again).

Other hedges become available if and when the position threatens to lose money. However, the strategy, as described, ignores all risk. It calls for holding through expiration as if nothing could go wrong That’s the second big flaw. The author suggests that one should anticipate seeing the sold option expire worthless more than half the time. But he ignores how large of a loss is possible when it does not expire worthless. He ignores reality.

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