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Thursday, March 7, 2013

Covered Put -- New Strategy (for me)

Here we go again, UNLIMITED RISK!     The entire idea that any option strategy or stock strategy, for that matter, gives you unlimited risk, is simply NOT TRUE.

The brokerage (in my case, Think Or Swim) will 'freeze' a certain amount of your account when you short options.  Think of it as them holding some "collateral" on the trade-- it is roughly based on a formula of two standard deviations which gives the broker assurance that his risk is covered.  BROKERS DON'T ALLOW YOU TO TAKE UNLIMITED RISK!  So the whole "infinite" or "unlimited" risk warning is keeping traders from making the kind of trades that could earn them money.  The pros have this market cornered, whether you realize it or not.

If you doubt this, just try to make a trade that requires more margin than you have in your regular margin account.  The trade will be rejected!  Your REAL risk is the amount of margin that the broker holds when you place the trade.  So forget this unlimited risk business and learn how to short some options and stocks!!

Now when the market crashes a la 1929, don't tell me "See?"  We don't live our trading lives as if the sky is falling, Chicken Little.


Okay, I'm learning  another strategy for an underlying when YOU EXPECT THE STOCK TO STAY STAGNANT OR GO DOWN.   (Sosnoff at TastyTrade, a confirmed Contrarian, used YHOO as his example in teaching his daughter, Case Sosnoff, how this works.)

Sell Stock and Sell an ATM put against it.  That's it in a nutshell.

For instance:

Suppose ABC stock is trading at $45 in June. An options trader sells a JUL 45 put for $200 while shorting 100 shares of ABC stock. The net credit taken to enter the put position is $200, which is also his maximum possible profit.
On expiration in July, ABC stock is still trading at $45. The JUL 45 put expires worthless while the trader covers his short position with no loss. In the end, he gets to keep the entire credit taken as profit.
If instead ABC stock drops to $40 on expiration, the short put will expire in the money and is worth $500 but this loss is offset by the $500 gain in the short stock position. Thus, the profit is still the initial credit of $200 taken on entering the trade.
However, should the stock rally to $55 on expiration, a significant loss results. At this price, the short stock position taken when ABC stock was trading at $45 suffers a $1000 loss. ($55 X 100) $5500 - $4500 SHORT = $1000 LOSS.
Subtracting the initial credit of $200 taken, the resulting loss is $800.

Think of this strategy as a mirror image of the Covered Call, BUT much lesser known and lesser used than the covered call.

A covered call profits from a stagnant or bullish move.

A covered put profits from a stagnant or bearish move.

Two chances to win out of three are pretty good odds, especially if your expectations are fairly lucky!

Happy Trading!

  • lly, you should buy to close the short put options.