Selling a put option is a slightly bullish strategy wherein the stock has to move up else the put seller may face a loss. Its better to sell a put option slightly OTM – Out of The Money. You must have read in lots of places that its better to sell an ATM (At The Money) put option, but my experience has been good with selling put options slightly out of the money. Out of the money put option gives you time to decide to book profit or take a stop loss.
Suppose you are very bullish on a stock then there are four things you can do:
1. Buy the stock in cash
2. Buy its Future
3. Buy an ATM Call option
4. Sell an ATM or OTM Put option
No. 1 is the best if you have enough cash to buy the stock and hold. There is no tension or worry about the trade finishing on expiry day. You can hold the stock till you retire.
No. 2 Future is the most dangerous trade of all four. In this month Jul, 2019 Yes Bank is going up 10% one day and falling 10% the next day – imagine the situation of a future buyer or seller caught on the wrong direction. But if it was a call or a put buy the trader would have managed to escape with a limited loss.
No. 3 is ok but you must have strong view on the stock. Plus the IV of the stock must be low to buy an option whether its call or put. But the biggest enemy is time value or theta decay. Sometimes even when the option buyer is right in direction, he loses the trade. Read this post to know issues with buying options.
No. 4 is good option if the trader wants to eat the time value premium of the option. However a stock crash might be dangerous so the trader must have a strong bullish view in the stock.
You must read news about the company before selling its put option. A company having financial, management or any other issue do not qualify for this strategy. In fact no trades must be done on such a stock.
After reading such news will you trade in Yes Bank?
Obviously, the answer is NO. Still, look at option chain and volume in Yes Bank as on 18-07-19 – there is heavy volume in options trading:
This is speculative trading at its best.
If you are reading this – make sure not to trade such stocks going in a bad new phase. It does not matter how bad the news is. Avoid trading in such a stock. You may suffer even if you short the stock because you do not know when the stock will rebound.
So selling a put option in such a stock is a Big NO.
What you can do if you have a very bullish long-term outlook in a stock? You can consistently sell its OTM put option month after month. Of course you must keep a limit to the loss you want to take in the trade. If that is reached you have to stop the trade. Same with profit booking. The stock will not keep rising forever so put a stop to your profits too if you are selling a put option of the stock consistently.
If you compare the results between a stock buyer and a put option seller you will see that the put option seller wins more times when the stock falls to the limit of the strike price of the option sold, stays at the same place at expiry, or goes a very small percentage.
What should you do when you sell a put option?
Keep limit to the money that you are willing to lose in the trade. Its not required for you to take this trade till expiry if the stock has fallen down. You are free to exit the trade if you see that the stock is falling and reached the level of the put option sold.
Note that selling put option strategy is a neutral to bullish strategy. You can sell a put option if the result of the stock has come better than expected, or the stock is not moving much or is witnessing huge spike up everyday.
Important points to note:
1. Do not use all money in your account to sell a put option.
2. Always hedge your put option sold.
3. Keep extra cash for adjusting the position in case you want to close the losing sold option and move to a lower strike.
4. Standard deviation volatility of the stock will give you an idea of how far you can sell a put option. However this does not guarantee that the stock will not hit the strike – but it does give you a general idea.
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