TOOLS OF THE TRADE

THE SHORT PUT

As discussed last week, short options come with obligations.  It is the traders’ obligation if assigned, to purchase the underlying stock at the designated strike price of the short put.  The risk in “selling to open” a short put is the strike price down to zero.  It isn’t likely that a stock would go to zero within the time frame that most traders typically sell short puts, however, it is possible.  The strategy takes advantage of “Theta” (time decay) of the option, so the preferred application of the trade is to sell the put with 30 days or less to expiration.  Time decay is very rapid within the last 30 day of the options’ life and it is only necessary for the underlying stock to remain above the strike price of the short put for the trader to profit.  Therefore, it is prudent to choose a strike price that is unlikely to be assigned. 

The following criteria should be considered when selling puts:

·         Sell puts only with 30 days or less to expiration.

·         Conduct your due diligence to determine if this is a stock that you would want to own, should you be assigned.

·         Do your chart analysis to determine the trading range and support levels of the stock.  Select a strike price that is at or below support.

·         Do a probability analysis using a probability calculator (which is readily available on the internet) to determine that the position has a high probability of expiring out of the money.

·         Consider buying a long put beneath the strike price of the short put as a hedge.  Not only will that provide a downside limit to your loss, it will also decrease your margin requirements to initiate the trade.

Examine and study the risk graph and develop an understanding of the risk/reward associated with this trade.  Next week, we will begin to explore combination and spread positions.  Best, Robin

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