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Selling a put might not be the first strategy you consider when you're bullish on a stock. However, history shows it might be worth the thought.
Selling a put commits you to an obligation to purchase stock at the strike price of the put sold. The put seller receives a premium to take on this obligation. At expiration, if the stock price is above the strike price of the put, the contract will expire unexercised, and the put seller keeps the original premium as profit. If the stock price drops below the strike price, the contract seller has the obligation to purchase shares of stock.
Applying the strategy
Here's an example to place some numbers behind this concept.
Let's say you have a neutral-to-bullish sentiment on XYZ Company during the next 30 days. XYZ is currently trading at $55, and you're willing to buy the stock for $50 a share. To take advantage of this, you could consider selling a put.
The 30-day $52.50 strike price put is trading for $2.50. By selling this put, you take on the obligation to buy the shares if the stock drops below $52.50. As a result, you're paid $2.50 per share. This effectively reduces our breakeven price on the stock to $50 ($52.50 buying price, less the $2.50 received from selling the put).
This graph View Graphic shows the profit and loss of the short put strategy (blue) versus simply buying the stock (red) at expiration of the put. The visual representation illustrates the trade off with this strategy. With selling the put, there is profit at any point above $50; however, the amount you profit is limited to the premium received from selling the put.
If you're interested in comparing the results of selling the put versus purchasing the stock, you would reference the indifference point. This point is where both selling the put and buying the stock would profit the same amount. The indifference point is calculated by adding the premium received from selling the put and the current stock price. In this case, the indifference point is $57.50.
$2.50 (premium received from selling the put)+ $55 (current price stock is trading at) = $57.50
Any amount above the indifference point depicts that owning the stock would have been a more profitable option. Similarly, if the stock is below the indifference point, selling the put was more profitable.
Selling the put profits if the stock goes up, stays the same or even it drops a small amount. This downside cushion helps if your market prediction is not 100% accurate; however, one sacrifice from receiving this cushion is that your upside is limited.
Tracking with the PUT Index
The Chicago Board Options Exchange (CBOE) developed the PUT Index, which tracks the performance of a hypothetical portfolio that sells S&P 500 Index put options against cash reserves. It tracks the selling of sequential one-month, at-the-money, cash-secured puts. This graph View Graphic shows the price performance of each strategy.
The next time you're looking to buy stock, it may be worth considering a cash-secured put strategy as an alternative.
Cash-secured puts can only be traded on the Scottrade OptionsFirst platform. To learn more about OptionsFirst, please visit options.scottrade.com or email at OptionsFirst@scottrade.com.
Options involve risk and are not suitable for all investors. Detailed information on our policies and the risks associated with options can be found in Scottrade's Options Application and Agreement, Brokerage Account Agreement, and Characteristics and Risks of Standardized Options (available at your local Scottrade branch office or from the Options Clearing Corporation at 1-888-OPTIONS or by visiting www.optionsclearing.com). Market volatility, volume, and system availability may impact account access and trade execution. Supporting documentation for any claims will be supplied upon request.
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