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Does Selling Put Options During A Market Downturn Provide A Safety Net?

InvestorEducation / Options & Warrants Jul 10, 2022 - 06:19 PM GMT

By: Chris_Vermeulen

InvestorEducation

In a significant market downturn, bearish sentiment, if not outright fear, can drive down the share price of good companies rather drastically.  When the market is in a sustained selling mood, there can be a substantial disconnect between the long-term fundamentals and the technical price action we see on the chart. 

The Temptation to Bottom Fish

What can we do when good companies are trading at what appear to be bargain prices?  We could “stick our toe in the water” and buy shares.  But what if we’re wrong about whether a bottom in the share price is in place?  Or what if the stock takes a very long time to build a base and goes nowhere for an extended period?


Selling Puts

Rather than buying shares, we could sell put options instead.  It’s a strategy famously used by Warren Buffett to acquire shares at a discount.

First, a quick review of put options.  Someone who owns or is “long” a put has paid a premium to have the right, but not the obligation, to sell shares to the counterparty at the strike price.  But that right exists only until the option expires. 

The counterparty who has sold, or is “short” a put, has an obligation to buy shares at the strike price.  That obligation is eliminated when the option expires, and the put seller gets to keep the premium collected whether they have shares “put to them” or not.

Although selling puts can be a way to acquire shares at a discount, traders (as opposed to investors) may just be interested in collecting the put premium as an income strategy.

Rules to Remember

We must like the stock at or around the strike price and believe it will recover over time.  Even if we’re just selling puts to collect premiums, keep in mind that we could end up owning shares. 

Of course, there must be options available on the stock.  The options should have good liquidity – decent volume, open interest, and bid/ask spreads that aren’t too wide. The strike prices near the current share price should have hundreds, if not thousands, of open interest contracts.  The bid/ask spreads on the options should be just a few pennies wide.  It’s usually a good sign of option liquidity if weekly, not just monthly, options are available.

What Makes a Good Candidate?

Look for companies with a long history of good earnings that have rebounded after many economic cycles.   The company sells a product or service that will likely remain in demand for the foreseeable future.  (No “buggy whip” manufacturers.)  A good candidate will likely weather the current storm and come out okay when the economy recovers.

Ideally, the share price is under $25, preferably under $20.   At that price level and below, the option premiums relative to the share price make for efficient use of capital and an attractive return on risk. 

Example Setup

Say company “ABC” was trading for $34 a share before the general market selloff but now is trading for roughly half that at $15.60.   There is “blood in the streets,” but overall sentiment may be improving.

The price action on the chart shows some tentative signs of bottoming.  A gap up with increased volume is a good sign.  A recent earnings report that wasn’t as “bad” as expected is another good sign.

In this example, the premium for the $15 put is $1.20 for an expiration 42 days away.  While the $15 strike is currently out-of-the-money (OTM), if we had shares put to us at $15, our cost basis would be $15 – $1.20, or $13.80. 

If the shares were trading at $14 at expiration, we’d have shares put to us.  But we would still be ahead on the trade with a profit.  We could turn around and sell those shares at $14 and have a profit of $0.20.

As options sellers, we’re selling time value that decays as the expiration date approaches.  We know that regardless of what happens with the share price, the time value we sold will be $0 at expiration. 

As an alternative to risking assignment, we could roll the trade forward rather than wait for shares to be put for us.  We could buy back the option on or near the expiration date and sell another option further out in time.  We can typically do that for a net credit.  In this example, we might be able to collect another $1 in premium.  So now our risk in the trade is reduced to $15 – $1.20 – $1.00 = $12.80.   

Summary

Put selling can be a savvy way to go “bottom-fishing” for good stocks, either to acquire shares at a discount or just collect option premiums.   Selling puts gives us a way to get “paid” while we wait for the share price to recover.  We can make a profit if the share price goes up, sideways, or even down a bit. 

want To Learn More About Options Trading?

Every day on Options Trading Signals, we do defined risk trades that protect us from black swan events 24/7. Many may think that is what stop losses are for. Well, remember the markets are only open about 1/3 of the hours in a day. Therefore, a stop loss only protects you for 1/3 of each day. Stocks can gap up or down. With options, you are always protected because we do defined risk in a spread. We cover with multiple legs, which are always on once you own.   

If you are new to trading or have been trading stock but are interested in options, you can find more information at The Technical Traders – Options Trading Signals Service. The head Options Trading Specialist Brian Benson, who has been trading options for almost 20 years, sends out real live trade alerts on actual trades, such as TSLA and NVDA, with real money. Ready to check it out, click here: TheTechnicalTraders.com.

Chris Vermeulen
www.TheTechnicalTraders.com

Chris Vermeulen has been involved in the markets since 1997 and is the founder of Technical Traders Ltd. He is an internationally recognized technical analyst, trader, and is the author of the book: 7 Steps to Win With Logic

Through years of research, trading and helping individual traders around the world. He learned that many traders have great trading ideas, but they lack one thing, they struggle to execute trades in a systematic way for consistent results. Chris helps educate traders with a three-hour video course that can change your trading results for the better.

His mission is to help his clients boost their trading performance while reducing market exposure and portfolio volatility.

He is a regular speaker on HoweStreet.com, and the FinancialSurvivorNetwork radio shows. Chris was also featured on the cover of AmalgaTrader Magazine, and contributes articles to several leading financial hubs like MarketOracle.co.uk

Disclaimer: Nothing in this report should be construed as a solicitation to buy or sell any securities mentioned. Technical Traders Ltd., its owners and the author of this report are not registered broker-dealers or financial advisors. Before investing in any securities, you should consult with your financial advisor and a registered broker-dealer. Never make an investment based solely on what you read in an online or printed report, including this report, especially if the investment involves a small, thinly-traded company that isn’t well known. Technical Traders Ltd. and the author of this report has been paid by Cardiff Energy Corp. In addition, the author owns shares of Cardiff Energy Corp. and would also benefit from volume and price appreciation of its stock. The information provided here within should not be construed as a financial analysis but rather as an advertisement. The author’s views and opinions regarding the companies featured in reports are his own views and are based on information that he has researched independently and has received, which the author assumes to be reliable. Technical Traders Ltd. and the author of this report do not guarantee the accuracy, completeness, or usefulness of any content of this report, nor its fitness for any particular purpose. Lastly, the author does not guarantee that any of the companies mentioned in the reports will perform as expected, and any comparisons made to other companies may not be valid or come into effect.

Chris Vermeulen Archive

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