Seasoned investors with options trading experience can reduce their acquisition costs and increase portfolio returns by writing naked puts on the stocks they want to own. This strategy has been used for decades by investors, and in 2019 the economics supporting a systematic put selling strategy were confirmed in a study commissioned by the CBOE and conducted by Wilshire Analytics.
Wilshire compared the risk/reward profiles of five option-based indexes (on the S&P 500) to those of asset classes typically found in investor portfolios. They concluded that options generally improved risk adjusted returns compared the unmanaged index. Importantly, one strategy that employs put selling was almost always the best performer among those they followed.
Its risk/reward characteristics outperformed in nearly every type of market environment. And while duplicating an index and selling puts against it would be a difficult endeavor for the average individual investor, the basic concept of selling naked puts to acquire stocks at a discount is sound. With that in mind, let’s walk through an example to see the mechanics and some of the benefits of selling puts.
In this example, we want to own a stock that’s trading right around $160 a share. It has rallied recently and we don’t want to chase it. But looking at the chart below, we can see that the recent rally has stalled, and the stock has pulled back a little from an overbought position. So where do we get in? Where do we set the strike price?
It looks like there’s some near-term support at 150, which was also a long-term level of resistance. So that looks like a reasonable place to set our target acquisition price at least from a technical perspective. Let’s also make the assumption the stock is also fundamentally sound.
Synthetic Limit Order to Buy
Selling a put is akin to a synthetic limit order to buy. The reason for this is that the strike price “limits” what we’ll pay for the stock if it trades at that level. The difference between a limit order and a short put is that selling the put lowers our net acquisition cost. This is because we collect option premium.
If we set a limit order to buy this stock at 150, then our cost basis in it would be $15,000 if our order gets filled. By contrast, if we sell a 150 put and bring in $2.45 of option premium, then our basis in the stock would be discounted to $14,755 (150-2.45 x 100). More importantly, if the stock doesn’t trade to our “limit” price, and we don’t get filled, we still get to keep the option premium.
As long as our investment objective doesn’t change, we can keep selling puts over and over again until we get assigned. The more we can do this the lower our ultimate cost basis will be in the stock. But put selling is not just an effective way for a long-term investor to acquire shares at a discount. For the trader, it is also an effective strategy to profit from a bullish outlook on a stock.
The reason investors sell puts is to acquire shares they intend to hold. But for the trader who would be comfortable whether or not shares are assigned, selling puts can be a more conservative approach than long call strategies.
Selling puts has two distinct advantages. The first is that time decay is in the trader’s favor. In our example, the short 150 put will increase in value by $11.90, with each passing day until expiration unless the stock price falls below that strike.
The position also becomes more profitable as implied volatility decreases. This leads to two other important points about this strategy.
The first is that implied volatility creates great opportunities for traders. The CBOE/Wilshire study points out that implied volatility (IV) is almost always higher than actual (or historical) volatility (HV). What it doesn’t point out is that whenever IV and HV diverge, they always get back together.
So shorting puts when implied volatility is high offers the trader a high probability of success as it decreases and gets back in line with historical volatility. The second point relates to the buy and hold investor.
If volatility rises over the next decade, then a short put strategy should also be very profitable for those looking to buy stocks at discounted prices. The reason for this is that volatility is the chief determinant of option premium. The higher IV is, the higher premium will be. These higher premiums translate to bigger price discounts for those interested in holding a stock long-term.
There are a few things that investors should consider before engaging in a put selling strategy. The first is assignment risk.
While the whole point of the short put is to get assigned stock that will be held for the long haul, the risk is that after assignment, the stock could keep falling. The total risk is equal to the price paid for the stock. In fairness, this is a greater concern for the trader than it is for the investor. Still, in theory, the stock could go to zero. The next issue to consider is transaction costs.
Commissions and fees will be due on every trade. They should be factored into the calculation. If puts are rolled over and over to generate income, a portion of the return that premium income generates will be consumed by transaction costs. Continually rolling puts highlights the final issue investors should consider the opportunity cost.
If the stock doesn’t hit the strike price over a long period of time, then the odds are good that it has risen in value. When this happens, the investor may have to accept the fact that this fish got away.
Lots of people would like to trade stocks and options for a living. Very few can do it. Making enough money to live off of trading isn’t easy. It requires talent, hard work, discipline and other factors that don’t come overnight. While we’re not saying you can’t be a successful stock or options trader without the components we detail in this article, they are factors that can make for a smoother transition and increase your chances of trading full-time.
In many contexts, there’s a significant difference between trading stocks and trading options. Some stock day traders often buy and sell within minutes or hours of one another. They’re looking for the smallest movement in price to bank whatever profit they targeted on the trade. While options traders can and often do trade like this, they tend to hold their positions for longer periods. Longer term stock traders may buy and hold for months and years. Options traders do not have this luxury as options have a finite period of time. Not to mention there are so many other variables in options trading. Managing the greeks, implied volatility and time decay.
One thing that’s constant (or at least should be) between the two styles of trading is having and methodically executing a plan. Without discipline, stock traders can get fleeced. If you have traded stocks successfully, you most likely followed a rigid, emotionless system that told you — objectively — when to pull the trigger on both ends of a trade.
You need to do the same thing if you decide to get serious about trading options. Having been there before in a similar context will have helped. Therefore, before diving into options its better if you spend some time trading stocks in some capacity.
Money-related stress can crush aspirations and deter focus. If you’re a serious trader, you will have a considerable bit of cash in your account (most likely $25,000 or more), and you’ll likely risk more money on trades than most people are comfortable losing. The last thing you want to do as you embark on what you hope will be a profitable trading career is gamble your future.
Before you start trading, you should probably ensure you have an emergency fund and a retirement account that’s on track to have you where you need to be when you want to retire. These two things must be separate from the cash you trade with. Trading should not be your retirement plan. It’s too uncertain, too volatile, and too difficult to win at enough times to turn out consistent profits, let alone fund your retirement.
It’s easy to become obsessed. With a girl. With drinking. With golf, With whatever. None of these things do you any favors at the end of the day. You cannot be obsessed with your job, even if it’s the difficult and time-consuming task of being an options trader. If you don’t have a life outside of your work, you’re going to drive yourself insane. If you’re insane in the way I describe, you’re not going to be an effective trader.
To be a good trader, I’m convinced you have to be able to relax not merely in the moment, but overall. If you sit down at your desk relaxed, don’t overreact emotionally when you’re in the thick of things, and walk away from your desk feeling good about your mental state, you will operate in a more productive frame of mind than the trader who chucks his or her monitor across the room the second something goes wrong.
So, find things to do that relieve anxiety and make you feel like you have more going on in your life than work.
If you had a dollar for every person who wanted to trade full-time and failed, you wouldn’t need to trade full-time because you would already have plenty of money. While the success rate is low, you do control your destiny.
Whether you have the three things detailed in this article going for you or not isn’t the issue. There’s a larger issue at play. And that’s going into being a trader by taking a thoughtful, holistic approach. How can you create conditions that make you ripe for success as an options trader? Do you have a plan? Can you stick to it? And will other non-trading related aspects of your life set you up for success or set you up to fail?
Coming at the process with this mindset creates conditions that should increase your chances of success. Steadydime is here to help. Try one of our options trading programs and we’ll do the homework for you.
For some reason, Jim Cramer has come up a lot in recent conversations. After having watched Cramer on CNBC and reading his articles on TheStreet.com, for several years, his name has only been brought up a handful of times in my post trading life. However, in the last several weeks, I have been in social situations with individuals who work in finance in some capacity (all independent of one another), so I guess it makes sense that Cramer has resurfaced.
I’m writing this article because I think it will help options traders and investors. I am also writing it because Cramer is one of the most misunderstood people in the financial and larger sphere of media. I hope Jim doesn’t get upset by us using his name in a headline. However, I’m hoping he won’t see it that way in this context.
When Cramer’s name comes up, people often react with a combination smirk/raised eyebrow. From here, I find myself wanting to defend him against what I perceive is their perception of him. This perception — that Jim is all style, no substance, and made up almost entirely of shock value– couldn’t be further from the truth.
While Cramer isn’t perfect (I’m sure he would be the first to admit this as no one is), he is a guy anyone in finance, including options traders, can and should learn from. The way he functions speaks to several general areas that will give you a fighting chance to make money trading. For anyone who has read Todd Harrison’s book The Other Side of Wall Street, you will already know this as Harrison was once Cramer’s Head Trader and speaks in detail of Cramer’s prowess as a trader an investor. Not too mention his insane worth ethic.
The thing I remember most about Todd Harrison’s book is how hard Cramer works.
Former writer at the TheStreet.com Rocca Pendola told me how he traveled from California to Wall Street several times a year when he was full-time at TheStreet. Rocco would get to the office super early. Early as in, there’s nobody else in the office early. But nine times out of ten Jim was already there, prepping for his morning appearances on CNBC and videos for TheStreet, writing articles, doing work for his subscription service, and managing his fantasy football team.
After spending several hours at TheStreet’s offices, Jim would go across the street to the NYSE for his CNBC hits. After that, he would come back to TheStreet, do his videos, write, and work more, presumably prepping for that night’s edition of Mad Money. From there, he would hop into a car waiting for him at the corner of Wall and New Street. (Apparently, Jim’s driver is the only person the cops permit to park illegally on Wall Street, it seems). He would cross the river to the Jersey side (credit: Bruce Springsteen for those words). Do Mad Money, go home, sleep for a few hours, and do it all again the next day.
So, he’s a hard worker. But that’s only part of what can help you as a trader. More than anything, Jim has a routine and sticks to it. I presume he’s still that way. It’s easier to know what to expect on a day-to-day basis, what to expect from yourself when you set a schedule and commit to it.
Along similar lines, if you’re not routine-oriented, you might not make a good trader, given that successful traders devise plans and methodically stick to them.
For as much and as hard as Jim worked, he also made time for other things. He exercises most mornings, is an avid gardener and likes to cook on weekends, and even opened a bar in Brooklyn. Having interests outside of your work schedule is crucial to fostering and owning the frame of mind that can make you a better and less-stressed trader.
Jim has a mind like a steel trap. I am not sure you can teach anyone to remember things (everything) the way Cramer does, but we can all strive to work on our brains in an attempt to get somewhere in the vicinity.
Anyone who watches Mad Money will notice the countless times you see Cramer rattling financials off the top of his head. It’s like a musician reciting her song lyrics. Jim knows and loves the stock market like nobody I have ever seen.
This requires something inborn, but also incredible focus. We can’t all come by it naturally the way Jim appears to, but we can work to get there. For a while, I was taking free online coding classes, even though I had no intention of being a software engineer. It helped me use my brain differently. And I’m convinced it made me better at everything else I was doing because it helped spike my cognition, mental sharpness, and ability to think quickly in a variety of contexts.
Rocco told me another great story about Cramer. He said he never forgot the year he went to TheStreet’s Christmas party. A young freelancer for TheStreet wanted to meet Jim. He was nervous and excited to meet Jim. So, Rocco let Cramer know, and he came over to introduce himself. But not only did he introduce himself, he put on a wholly genuine show.
The most amazing thing he did was talk specifically about this writer’s work, both complimenting it and considering where it might go in the future. There’s that mind like a steel trap again. However, it’s more than that. Jim made this freelancer’s day by taking a sincere interest in what he was doing. By making the interaction more than a handshake and smile.
I’m not sure this will directly make you a better trader. However, it will make you a better person. And that’s a worthy goal as well.
Many novice traders think that making money with options is simple. One merely needs to guess the direction a stock will move correctly. Get that right, and you’re a winner. If you think the stock will rise, buy a call. If you think the price will fall, buy a put. Do that and you’ll make money every time.
Ah, if only it were that simple.
That kind of naïve view of options trading is akin to thinking that chess is a simple game because it’s played on a checkerboard.
The truth is that trading options is very much like playing chess. Neither endeavor is simple nor straightforward. Without a keen understanding of fundamentals, both pursuits can be frustrating. In the case of options trading, that frustration is typically accompanied by losses of real money.
A chess board is an alphanumerically labeled grid with the numbers along the vertical axis and letters along the horizontal axis. The board doesn’t display these numbers or letters, but experienced players know they exist. It’s how tournament champions diagnose other players’ moves and their own mistakes after matches. Importantly, the grid structure and virtual labeling make it possible for computer software to emulate the board and come up with playing algorithms. And, indeed, people do play a lot of chess on computers.
A chess match places two players, and their pieces face to face horizontally. The object of the game is to move pieces so that an opponent’s King is compromised in an indefensible position. The simplest way to make that happen is to control the center of the board from beginning to end, defending a position, and killing the opposing player’s high-value pieces.
Easy, right? One player marches a miniature army across the board, killing the opponent’s pieces until that player’s King is backed into a corner. And checkmate! The game is over. The problem is there is no way of knowing what the other player is thinking and how he or she might react to any of his or her opponent’s moves. Both of them seek to control the center of the board. Each player has the same objective, and only one of them can win. Both players can sacrifice pieces on the board to gain a strategic advantage. And each of them has their eye trained on their opponent’s King. But with every move, the dynamics change.
In a roundabout way, options trading is also performed on something of a grid, laid out not alphanumerically, but still with important information displayed along vertical and horizontal axes. The images below display an options matrix for a given stock’s calls and puts. I’ve broken the matrix into two pieces to make it easier to view. Importantly (and intentionally), this matrix doesn’t show option premiums. It displays what experienced options traders will recognize as the “Greeks” for each options series running up and down the vertical axis.
As you can see, each Greek of each strike for each expiration has a different value. And each one of these Greeks affects all of the others. That’s the case for both types of options, calls (above) and puts (below). With every tick of a stock’s price, up or down, the dynamics change — every one of the Greeks changes.
In fairness, I could have shown an options matrix that displays premium, the price an options buyer will pay, or a writer will receive. But the point here is to explain why options trading is so complicated. The Greeks are the reason that an options trader who correctly picks the direction of a stock’s price can still lose money.
The skills necessary to be successful at playing chess are the same ones an investor needs to be successful trading options. There are certain constants in both endeavors. These are discipline, preparation, analysis, purpose, versatility, risk management, and composure. Let’s look at how each one of them relates to both playing chess and trading options.
Successful chess players have a predictable pattern of how they move pieces around the board. Their opening moves are generally the same. They are consistent. They are disciplined. Their manner of play is focused, strategic, and deliberate. This is the same for successful options traders. To be successful, they must also be consistent. They must do the same things every time, without exception. For chess players as well as options traders, the worst trait to have is a lack of discipline.
Being disciplined also means that the steps one takes before execution are also consistent. This is the case in chess and options trading. Chess Grandmasters don’t go into matches haphazardly. They prepare. Likewise, successful options traders don’t enter trades without proper preparation. The chess player must understand and prepare for an opponent. He or she must know what the opponent’s strengths and weaknesses are. The same is true of any options setup. The trader must understand how a given trade structure will perform under different circumstances. A long call spread will behave differently than a long calendar call spread, and the trader needs to know which one is most likely to achieve its intended outcome. Proper preparation moves both the chess player and the options trader closer to their intended result.
Part of preparation means analyzing the environment. The chess player needs to consider the other players in a tournament to determine how to play each possible matchup in the various brackets leading up to the finals. Likewise, the options trader needs to consider the many variables that could impact the success or failure of a particular trade setup. As the chess player needs to evaluate the competition, the options trader needs to consider the variables that affect a trade. The options trader needs to know where support and resistance are, how implied volatility compares to historic volatility, and what the potential is that some event could cause a sudden price change in the underlying stock, such as a dividend payment or earnings announcement.
All of the above analysis needs to be considered in the context of both the chess player’s and options trader’s specific goal. Both want to win. For the chess player, this might mean moving up through each bracket and playing in the tournament’s final round. Maybe it means achieving a personal best. Maybe it means something else. For the options trader, it must mean closing out the trade profitably. Yet what is appropriate for one trader may not be acceptable for another. For one achieving a 10% return might be a reasonable goal. For another, it might be something higher than that. For both the chess player and the options trader to be “successful,” they must have a stated goal or purpose for what they are about to do.
Setting goals helps frame the focus for both the chess player and the options trader. Having an intended purpose helps each to visualize and work toward an intended singular outcome. But things don’t always go as planned. So, both the chess player and the options trader need to be versatile. They need to be able to think on their feet and change course when necessary. For the chess player, maybe this means looking ahead and altering planned moves to counter an unanticipated attack by an opponent. For the options player, maybe it means closing one leg of an iron condor as a stock breaks out of an originally anticipated range. In either case, being flexible to respond to unexpected changes can help both the chess player and the options trader make the best of a bad situation. This is what separates the champions from the amateurs.
Being versatile, however, doesn’t mean stubbornly committing to an alternative strategy that fails to achieve its intended purpose. Even the best chess players can embark on a game plan that doesn’t work out. At a certain point, understanding that a draw is a preferable to a loss sets the new best-case scenario. The same happens in options trading. Now and then, a trade does not work out. For the chess player altering moves to force a draw limits the players risk. For the options trader closing a setup at a small loss also helps to mitigate risk. Risk management means reserving capital for the next trade instead of risking a total loss hoping a trade will turn around and work out.
Reserving capital for the next trade isn’t just an economically sound move; it is also psychologically sound. Successful options traders know they can’t win on every trade. So do successful chess players. Losing is part of playing the game. The successful players and traders take that in stride. They remain focused and devoid of any negative emotion that can get in the way of performing at the top of their game.
The alphanumerical grid of a chess board has led to algorithms that make it possible for people to play the game on computers. Software programs even help teach kids to play chess. Maybe someday chess tournaments will pit top-ranked humans against machines. Who knows?
One thing is for sure, while chess players don’t currently have to compete with computer algorithms to be successful, human options traders do. The reality exists that some day in the future algorithmic trading and artificial intelligence will dominate the options market. Even when it happens, I’m convinced that a trader behaving like a chess player and following the seven rules above will have ample opportunity for success.
At first, they’ll intrigue you, but you might rule them out as not for you.
Soon, there’ll be a second glance. Maybe you’ll read an article about covered calls and realize you can seriously maximize your investment income by writing a few. Covered calls — and using puts to hedge — tend to be the gateway drugs to more advanced options strategies. We have seen more than one trader or investor take this righteous path.
That said, if you don’t properly prepare and set yourself up for success, options can take you on a bad trip. In this article, we detail a few things you need as you get set to take the next steps trading options.
Sounds basic, but it’s not. You can’t go into any set of serious options trading strategies without an ample amount of cash.
Not only do you need cash to execute actual trades, but you should have sufficient equity in your margin account and just general liquidity to support your trades. As a basic example for illustration purposes, let’s say you write (sell) a put, which sets you up to buy a stock below its market price at the time you sold the put. If you are “put the stock” (meaning you have to buy it), you’ll want to ensure you have buying power to do so. Your brokerage will help you keep tabs on this, but it’s too easy to get into trouble selling naked (not secured by cash) options.
We group these two because, without time, it’s extra difficult to be patient. And this ties back into having a (more than) comfortable cash position for life and your trading endeavors.
Any type of trading, particularly if you rely on it to make a living or fund meaningful goals such as retirement or buying a home, takes a significant commitment to get right. Learning the ropes of something as potentially complicated and nuanced as options trading is a process. You can’t expect proficiency, let alone success, overnight. You’re going to make mistakes (another reason why you should have a fair bit of cash). But that’s good because you’ll learn from them.
You’ll discover why you made the mistake, see it coming next time, not repeat it, and execute a winner rather than losing trade. It’s a beautiful thing to experience; however, you have to let it happen, remembering that it’s part of the process.
Respect the process. It’s easiest to do this if you have patience and time.
When I started to learn about options, I was in my early twenties, and there were limited online resources at that time. I ended up subscribing to Schaeffer’s Research Option Advisor which was an options trading service. It was mailed to me once a month and I paper traded the recommendations. Finally, I saved enough scratch to start swinging some options for real and at the time the extra $500-$1000 a month felt like I hit the lottery. Without my options subscriptions service, I would not have learned options to the extent I needed to. The service along with books I would read while sitting in Barnes & Noble and devour helped me become reasonably well-versed in options.
Find a situation like this. It might be signing up for a reputable options trading service, such as the one here at SteadyDime or like the one I mentioned above Option Alpha. Although no guarantee for the price you pay you typically receive income back far exceeding the cost of the subscription. Forget for a minute the trade recommendations but the education you receive is well worth the cost. It might also be finding people you meet from these sites on the forums that help you along the way. The association of traders in these subscriptions sites truly are a community and love to share ideas. While you can certainly learn how to trade options on your own, there’s nothing better than having a partner or being part of a populace where you can seek support and get answers to questions on the fly or with a long-term perspective in mind.
Cash, patience, time, and support. You probably need these things for most of life’s journeys. That said, too many people idealize the notion of trading for a living. They think it’s going to be easier than it is. They come in unprepared — without cash, lacking patience and time, and minus adequate support. These people tend not to last long as traders. If you want to stand the test of time, take the time from day one to make sure you have the tools necessary to succeed.