Gurgeh
Silver Baronet of the Realm
- 4,655
- 12,611
Keep in mind it's a tool when you want to bet against the market, and not only do you believe that the price is going to drop, but also that you can estimate how much it is going to drop. If it drops more than what you had estimated, it would have been better to wait with your cash and buy the shares at the expiration. Also, if the market goes up, you're losing money compared to having invested in it. Basicaly if this example, you win money if the price of the share is betweeen ~266 and 295 two months in the future, if it not, you lose money. It is a tool for expert traders.For anyone interested in learning an option strategy, I'll explain a little selling a put. Feel free to ignore this post if not interested
Let's say an investor is watching the S&P 500 who has $200,000 and is considering his options from now till year end. For whatever reason (geopolitical turmoil, valuations, possible recession, horizon for needing cash etc.) they decide the market is overvalued at today's price of $291/share. He does however believe he would be interested in buying into the market if it were to drop to $270/share (about 10% off ATH ie a correction). So this investor leaves his cash in a money market account earning about 1.8% and waits to see if the market drops to his desired level. So we have two possible outcomes, the market fails to reach his $270 level and he will make about $900 in interest during the three months or the market will drop to $270 or lower and he will invest.
Now what he could have done. is sell a PUT option. This is a contract to purchase shares at the strike on or before expiration. If he looks out to year end we have option contracts that expire on Dec 20, 2019 (There are weekly, monthly, and quarterly options and on an ETF like SPY there is a plethora of available choices for all time horizons.) Today's closing price on a $270 put contract on SPY expiring Dec 20th is $3.54. A single option contract is for 100 shares of the underlying security. So for each contract he would sell there would be $27,000 ($270x100) of obligation. This means that our investor has enough cash to cover 7 put contracts ($27k x 7 = $189k cash to secure) So the investor sells 7 contracts at $3.54 and immediately collects $2,478 that will be credited to his account. The three months pass and the investor will still collect the money market interest plus his money from selling the puts ($2,478+$900=$3,378). If the price of SPY is greater than $270 on Dec 20th the puts will expire worthless. The cash is freed up again and the investor keeps his $3,378 OR the market does indeed decline and on Exp day SPY is trading less than $270/share. In this case the investor will find himself the new owner of 700 shares of SPY @ $270 (at a cost basis of $266.46/share)better than the price he previously decided he would be interested in owning it at.
While most would agree that making $3,378 is nicer than $900 for an individual who was wanting and willing to buy SPY at the strike ($270) in Oct three months prior there are a few pitfalls to this.
1. SPY may drop below $270/share prior to Dec 20th and then recover. Now our investor could not purchase shares with his $189k because that cash was securing his put obligation. If the investor at that moment chooses to close the position (buy to close) he will pay a rather tidy sum because the value of the put will have risen potentially significantly from the time it was sold. This risk could be mitigated with yet further options strategies at that point but I don't want to over complicate it but to show that there is risk related to TIMING. This timing risk can be more straightforwardly be mitigated by selling options that are closer to expiration. In this scenario sell 7 of the 10/18 exp , then the 11/15 and then the 12/20 as each date comes up. This makes it more likely that the investor will get his shares if the market does fall to below the strike.
2. Another risk could be that SPY falls well below $270 so that at assignment you enter the position already significantly down. For example SPY falls to $250 on 12/20 you are now ($14,000) in the red at the time you receive the shares. To me this risk is not really a risk of the option contract but more how we perceive it. Remember we started this idea with the investor saying "I would pay $270 for SPY" well whenever a buyer established the price he will pay and acts, there is no way of knowing if a lower price could be had a week later that is an inherent risk of investing. If you lie to yourself at the start when picking the strike you will learn to regret it real quick then when your steadfastness it put to the test. It's easy when the market is at highs to say you would buy it cheaper. But cheaper doesn't come without the fear that drives the price there in the first place. Some investors then when faced with that fear find themselves flat footed when months earlier they were quite sure they would act.
It is this behavior that makes timing markets too precarious for people because it's easy to sell the market it's much harder to get back in. This is a reason I actually like this put option strategy because it locks you in when you have balls of steel and makes the decision upfront when you are of clearer mind and not in the moment of panic.
3. If the investor needs the cash during this 3mo. period there is a reasonable chance he can't exit the position without loss. Now this is again not a particular risk outside of the standard consideration of our investment horizons and need for money in the future, but I list it because it is a con compared to the money just sitting in a MM waiting for SPY to drop because each day the investor could change his mind and apply the cash elsewhere.
These risks should not be surprising as nobody is going to hand you $2,478 for nothing, but the risk compared to an investor who wants to be invested and is not comfortable with current levels, it is a much more efficient management of cash. There are more details and things to elaborate on but in the interest of brevity and not wanting to make this too confusing I try not to get too thick into it beyond what is needed to convey the idea.
If that is interesting to at least one person then I'm happy and could maybe even be helpful to someone in the future.
If you don't have good reason to think that the market is going down, you're better off being invested in it, because the value of the PUT is computed with a low/no risk discount rate, i.e. far less than the average market performance. If you believe the market is going down, it might be prudent to keep your cash and handpick the time you're buying, because you might think TODAY that 270 would be the fair value, but if it drops to 270 three days later, your expectations are probably going to change and your you'd probably not be investing 200k on them but wait for it to drop more.
I'm pretty sure that PUT is a tool that on average is losing money to the individual investor, especialy the non-expert one.
