Selling puts

I've heard that about 70% of all puts and calls expire worthless. I'm considering an approach of selling out-of-the-money puts, and to protect against the underlying stock having a massive decline, taking the loss if
the put doubles in value; i.e. if I sell it for $ 1, I'll buy it back if it goes to $ 2, but if it stays above $ 2, I'll wait until the expiration date, hoping it expires worthless.
If more than half expire worthless, I should come out ahead. If not, it means that the bear market is back and I need to lay low or start selling puts on options on ETFs that short the stock/
Has anyone got any advice on this approach? One year I made $ 60,000 selling puts, then lost it all when the market turned down. I think I should have followed my above-stated exit strategy. Hopefully I learned to cut those losses.
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Not necessarily. Even if almost all of them expire worthless, all it takes is one to move massively against you and you'll lose money on the whole shooting match.
If you graph out virtually any option strategy you'll see there's a (not quite literal) "conservation of risk". The wider the price band of the underlying in which the strategy is profitable, the less the profit is and the more disastrous the non-profitable zones will be.
[Reminds me a bit of fourier transforms from my EE days -- the more spread out a signal is in one domain, the more of a single spike it is when transformed to the other domain.]
-- Rich Carreiro snipped-for-privacy@rlcarr.com
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writes:

now includes an exit strategy. If there is a massive move but you take the loss before you lose more than your potential profit that would prevent huge losses--UNLESS there was vary large sudden move like if you sold a put for $ 1 and the stock dropped suddenly from $ 100 to $ 70 before you knew what hit you. That shouldn't happen if you stick to ETFs like SPY. Of course there are times when even with the best plan, the market could consistently move against you and the best plan would then be to stand aside.
I'll be testing it out on a small scale.
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That depends on the frequency of large stock market drops and the level of option premia. Emprically, option selling strategies on the S&P 500 have been profitable -- one can look at the BXM and PUT indices of the CBOE http://www.cboe.com/micro/BuyWrite/introduction.aspx .
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Cash covered puts is equivalent to covered calls. My brokerage account doesn't allow me to sell puts (ignorance on their part), but I can sell covered calls.
Selling puts lets you avoid buying the stock and paying an associated commission.
Selling options work best when the stock doesn't have much downside and options have a high time premium.
-- Ron
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wrote:

==I can sell uncovered (cash covered) puts in my IRA, but not uncovered calls. A covered put would require you to be short the stock and a covered call requires you to be long the stock. My broker charges a commission when I sell a put, and if it is in the money, expires, and is exercised I'm also charged the commission for the purchase of the stock If you sell an uncovered call at a $ 5 strike price and the stock goes up to $ 100, you could lose $ 95, but if you sold a put on that stock and it went to zero you could only lose $ 5.00. That is why a broker can allow you to sell puts, but will only allow you to sell COVERED calls.
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That seems to depend on the brokerage. When selling cash covered puts in my IRA, the brokerage required me to buy treasuries equal to the strike price.

If you don't have enough liquid assets to buy the stock at $5, the broker won't let you sell the puts.
-- Ron
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-- That is correct. If you sell a put with a $ 5 strike price, you have to have $500 in liquid assets (generally cash) to buy the stock if the put were exercised immediately (or later).

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The problem with these sorts of schemes is that you are going head to head with the trading floors of the investment banks. The question you need to ask yourself is "If this is so good, why aren't they doing it and taking all the profit out?"
Those guys have got armies of MBA's and quants and rooms full of computers looking for these kinds of opportunities. You need to figure out how you can beat that.
-- Doug
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[snip]

One doesn't have to make more than they make, to profit. Garbage in, garbage out, still is true, as the recent financial crisis has shown, again.
The 1987 Black Monday bankrupted a lot of guys who had open puts on the indices. Since then, put premiums have been w-a-y higher than ever before.
A cash-covered put means there is sufficient cash in the account to purchase the stock, if it is assigned. It is possible to pick up single-digit percentages selling cash covered puts, but for me, I'm always ready to take the stock, and the reverse with covered calls. This is very different from Diogenes' trading strategy.
Diogenes might look into spreads (most of the 'pros' do, to cap downside). The CBOE sells a definitive CD. The profits shrink, as well. But in trading, the real trick is to be nimble, recognize being wrong *immediately*, and manage cash. Those black swans have very hard- hitting wings as Mr. Carreiro succinctly points out.
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==Those clowns have proven that their "picks" rarely outperform the S&P 500 in an unmanaged fund. I learned almost nothing about the stock market when I got my MBA.
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As someone who does about four option trades a month, and who has consistently made money at it for years, I can say your basic premise is incorrect. Options are priced to be a *zero-sum* game. All things being equal, if you sell puts (in or out of money, long or far), they are priced in a way that if you hold to expiration, on average, you will make zero.
In practice, as a retail buyer or seller, you will not realize a zero sum because of the illiquidity and high spreads for most options.
So if you sell puts and expect statistics to reward you, you are in for a surprise. 70% of the time statistics will reward you and 30% of the time statistics will give you a whack on the head. :) Overall, you won't average out in the positive, particularly if you do it for a long enough period of time.
Averages are benign, but the extreme standard deviations can wipe you out completely. Most people who sell premium make the mistake of not sizing the position correctly, and that can lead to bankruptcy quickly. In sizing a position, you should assume that that the stock will be assigned to you at the strike price, and that you are at risk to lose 100% of that stock investment (just as you would be if you bought the stock outright). For a small portfolio, you might be willing to risk 5% of your equity in one stock. So size the options you buy so that you are never exposing more than 5% of your principal to stock or index you are going to be forced to buy if things go bad. I've seen people playing options put 20% of their equity into just the purchase price of a short option position, not realizing that if the stock collapses they are going to realize a loss on that position that exceeds their entire net worth. It seems like an obvious point, but unfortunately options seem to attract a large component of people with addictive gambling personalities who simply don't understand how to calculate risk and reward. Options are extremely unforgiving to such people.
There are probably dozens of valid methods for making money on selling puts, but the only method that has ever worked for me is to calculate the value at which I am willing to buy a stock, and then look for situations where selling a put lets me buy it much cheaper than that. For example, one position I am watching now is for a commercial construction materials company that was refinanced recently, and the new investor massively diluted all the common shareholders. The new investor is buying in around $2/share. It's common in such situations for the stock to sell down close to the price the investor paid, and sometimes to a lower price. With the stock trading at $2, the March 2010 $2.5 strike put is likely to be trading at around $1.20. So if you sell short that put, you are effectively willing to buy the stock at $1.30. Assuming you believe the company was worth the $2 the investor put into it, and that this represents a real bottom value for the stock, you are able to get the stock at quite a hefty discount by selling the long-dated put. Looking at it another way, you are being paid $1.20 to put $2.50 at risk, in a stock that you believe won't lose you more than 50 cents as a worst case. That's pretty wonderful balancing of risk and reward no matter how you do the math.
If I think the stock has tremendous upside, I would just buy the stock. No reason to limit my gain by selling a put. But if I'm bottom feeding on a stock that I think will be challenged to rise quickly, selling a put gives me a way to realize a super-deep-discount and then effectively close the position at a better price just from expiration of the premium on the option. That's an example where you invest based on fundamentals, and exploit the fact that options are priced based on statistical movements.
--
W


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