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3.18.2017 - Financial Intelligence Report Bookmark

The Commercial/Selling a Put
 
I got an email the other day from a gent who was watching TV, and a commercial came on. In that “financial” based commercial, there was a conversation between a client and what appears to be either his broker, or advisor. In the flow of conversation, the advisor says to the client, “well we might consider selling a put...”  to which the client says something like “that’s an interesting idea.”

So I got this email, and Joe R. asks, “Bob, what’s up with selling a put and why is that an interesting idea?” I thought maybe others might be interested in the answer, so I told him I’d address it to the subscription base.
 
If you don’t know how options work, then this is going to sound like goblety -gook. But even if you do know about buying calls and puts, “selling” a put is in a different category.  You’ll need to pay attention because the differences are many. 

The following is from an options tutorial I wrote years ago, and sometimes parts of it come in pretty handy.  This is one of those times, because later in the tutorial you’re going to see why in that commercial the client thought that selling a put was an “interesting” idea. 

Naked positions

Today we’re going to end with one of the riskier aspects of options trading, called “selling naked”. While it is indeed more risky, meaning you have to really manage that risk, however along with the risk comes big rewards. So, let’s get to it...

As you know if you think a stock is going to rise you can buy a call option and if you are right, your call option will appreciate in value. On the other hand, if you think a stock is going to fall you can buy a put on it and sure enough if you are correct and the stock falls your put increases in value and you have made a profit.
 
 That being said ... there are other ways to play this option game and in this section we are going to look at one of them. As a technical term it is called "selling a naked put" and although the name sounds a bit kinky...believe me that is the true name. The first thing to keep in mind as we go forward is that this technique is very profitable if done correctly and any time the market is going to reward you with higher profit's...instantly you should think higher risk.

If you are confident that a stock is indeed going to move higher, instead of buying a call option against it, we can sell a put option. Whoa now...this is obviously a completely different approach so let's go slow. If a stock is going up, what is happening on the put side? (Remember you buy a put if you think a stock is going to fall because it increases in price) It goes down in price value right? Right. This is the key here and it is a bit confusing because you have to think somewhat reverse.

Let's try using a fake example to get the idea under our belt. Suppose we think XYZ is going to continue climbing. It is trading at 50.45 and we look at the 50-dollar May Put and see it is getting 4 dollars per share. Let's say we SELL 10 contracts of the May 50 puts. Since options are sold in blocks of 100 shares called a contract, we have just sold 4,000 dollars worth of puts. That $4K goes right into our account.

Now let's also assume we are correct and XYZ slowly climbs to 53.20 dollars in a few weeks. What do you suppose happened to the May 50 dollar put price? It fell.  Let's say it is now mid - late April and they are now getting only 1 dollar for them.
 
What we would then do is simply buy back the puts we sold and the difference is our profit on the trade. In this case, it is $3,000 dollars. ( we sold 10 contracts for 4 dollars per share, which equals $4,000. Now we’re “buying back” our 10 contracts but at just 1 dollar per share. The difference is $3,000 and that’s all ours) This is the basic idea of how it works and you should study that example until it is clear what we are doing. We are selling a put option for some amount of money and then if the stock rises,  buying it back for less than we paid. The difference is ours.

So why do it instead of simply buying the call? Well first, a put will decline in price faster than a call will increase in price,  on a rising stock. Second, we always have two sides to any option...the intrinsic value and the time value. So every day that goes by,  that put is declining in value simply because time is getting eaten away.
 
Even if XYZ doesn't move a dime in either direction from 50.45 dollars, the puts you sold will be decreasing in price simply because time is ticking away.

Let’s examine what I just said, because a LOT of money has been made via time erosion.  In options, there’s TWO components to the price. One is the underlying “intrinsic” value if there is any, and second is the time value.  So, let’s suppose we are just 2 days away from options expiration Friday, and ABCD is trading at 52.75 You look and see that the 50 dollar put that will expire in 2 days is worth $0.20. Yes it’s worth just 20 cents. So, you sell 20 contracts of that 50 dollar put.
 
What you just did is sell 2,000 “shares” at .20 cents a share. You just took in 400 dollars. As long as ABCD remains over 50.00 by the end of that Friday, that 400 bucks is yours. Forever. The contracts have expired and there’s no more obligations.  That’s why many times you’ll see hundreds of put contracts showing up the day before expiration day. Even if they’re only worth a nickel, if you sell 100 contracts, it’s a payday.  ( just pray ABCD doesn’t fall like a rock, or you’d be obligated to buy all those stock shares! I talk more about that below)
 
If you combine the time value erosion with the mechanics of how a put price will erode on a rising stock you have the makings of a very fast price change. This is why this tactic is so profitable if your assumption about the direction of the underlying stock was correct. The down side to all of this is that if you are wrong and XYZ doesn't rise, but instead falls like a rock...you are going to lose money just as fast.

There is another problem and this is where the big risk comes in.

 Remember when we BUY a call option we have the RIGHT but NOT the obligation to buy a particular stock at a particular price, by a particular date. When we buy a put option, we are buying the right, but not the obligation to do something. However...
 
When we SELL a put option we are taking on a responsibility and an obligation. Basically what we are doing by selling a put is giving someone the right to "put" the stock to us at a certain price.
 
That is right folks you are doing a legal deal here and you are selling the right for someone to "make you buy" the stock at the strike price you sold. For example we sold 10 contracts of XYZ 50 dollar puts for 4 dollars per share right at that moment we entered an obligation and what happens if XYZ doesn't rise like we thought and instead falls to 45?? Someone can "make us" buy it (the actual stock) from them at 50 even though it's trading at 45 on the open market!
 
This is something you must avoid and to do that, what you would do is simply buy back the puts you sold, but at a higher price.(you lost money)  Remember puts increase in value if the stock falls so those puts we sold for 4 dollars per share when XYZ was at 50.45 are going to be much higher if instead the stock has quickly fallen to 45 (maybe 10 dollars) now. Hopefully you didn't wait that long and you bought them back when the stock was falling and only lost a small amount of money!

So as you can see selling naked puts is a very profitable thing to do if you are right in your assumptions of where the stock is heading. If the trade goes sour though...you will lose money quickly.

HERE is where the “commercial” comes into play:

Selling puts relates ESPECIALLY to you long-term holders or "investors." One of the more beneficial reasons to sell put options is to "get paid" for buying a stock you actually want to own anyway. How's that?? Okay, let me explain ... If you aren't in a huge hurry to buy into a position, selling a put is a great way to get the stock at a reduced price. This is how it works...

 Suppose you want to own 1000 shares of the XYZ company really bad, but you think it's trading a bit too high right now. Let's say it is trading at 48 dollars per share and you think it will fall back to about 45 and that is where you would buy it anyway.

So we look and see that the June 45 puts are selling at 2 dollars per. So what you can do is sell 10 contracts of those June 45 puts. This will generate 2,000 dollars into your account immediately. Now, let's say your assumption was correct and XYZ falls to 44 .70. You have sold someone the right to "put" the stock to you at 45 so sure enough...you own it now. (If the stock only fell to 45 even, you may or may not have the stock "put" to you but if it falls further than 45...the option will get exercised and the stock will be delivered to you) But look at what just happened closely.

You wanted to own XYZ, but while it was trading higher than 45 you considered it too expensive. By selling the puts against it, you took in 2 thousand dollars, and  because the stock faded down under 45, on June 16th the stock you wanted at 45 anyway was indeed given to you. But now your actual cost basis in XYZ is 43,000 dollars not 45,000. (1000 shares of XYZ at 45 dollars per share cost 45,000 dollars. But you were paid 2,000 dollars by selling the puts, so 45,000 minus your 2,000 = 43,000)

By now it is obvious that this is a very effective way to buy stocks that you really want to own.  Naturally, if the stock never drops, you might have to play a game of “catch it”, but at least you were paid a couple grand to help out.
 
So for those of you who’ve seen the commercial and wondered what was so interesting about selling a put, now you know. Hope that helps, Mr. Joe R.
 
The Market...

I know it was option expiration day, but once again the market couldn’t put in a green close. It tried, as we were green for a large portion of the afternoon, but when the bell rang, we were red once again.
 
If you look at a chart of the DOW, you see something interesting. More times than not over the last 12 sessions, the only gains have really come via way of a morning gap higher, not organic increases intra day.  In fact, over the past 12 sessions, we’ve only had ONE decent up day where the market actually made gains during the session.
 
You can call it what ever you’d like. Digestion, consolidation, working off the excesses, etc. But what it is, is a boring, flat sideways chop. Now, the age old adage about the market is that you “never short a dull market”. The idea behind that is simply: When a market is sideways and flat for several days, it often has a habit of spurting higher, just when you figure it’s finally finished and ready to roll over.
 
A perfect example of that, is the chart below which is courtesy of stockcharts.com. Notice the way the market was sideways and choppy and boring inside those red boxes I drew? Then “boom” up it went, only to enter a new period of sideways and choppy.
 
 
So the question is... is that what we’re seeing right now? A new period that could take us sideways for weeks and then “boom” another spike higher? That’s what the bulls are preaching. For me, I could see that happening, yes. But as long as you understand the why of it. It is NOT because of growth. It’s not because of better economic reports. It is simply because... the system needs stocks to go at minimum sideways and at best, up.  Why? Because it’s all leveraged.
 
After the 08 melt down, they threw the kitchen sink at trying to create a wealth effect. This isn’t fantasy, as ex Dallas fed head Richard Fisher said it point blank on CNBC..”we pushed the markets higher to create a feeling of wealth”.  Yes they sure did. And in doing that, so many people figured that the Fed’s would never let the market fall that they leveraged everything to buy stocks and use them as collateral.
 
So the market is literally “rigged” to go up by the central banks of the world. If it was to really contract, the damage would spread uncontrollably. This wouldn’t be just mom and pop losing a few grand in their E-Trade accounts. This would be sovereign wealth funds, pension funds, hedge funds,insurance companies, etc. They all bought into the idea that “the Feds have my back”. And so far they do. Until they either don’t..or can’t.
 
So paranoid are they about losing that control, they haven’t even let the market fall a single percent in 100 days. That is NOT normal action folks. That is “them” buying up futures any time they even smell a correction brewing.
 
But one day, it is going to end. I don’t know the day, or the how. But it will. I will say this...this market has WANTED to pull back and clear itself many times over the last 100 days and each time, it was cut off at the knees.
 
So we continue to try and lean long, with small positions. We know that on any day right out of the blue, something could happen and they lose control of this thing. But until it comes, we nibble around the edges. It’s a terribly frightening time, it really is. When a market is at levels it doesn’t belong at, and a fed head admits “yeah, we did that”... what happens if they “don’t do that anymore?”  Ponder that. 

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