Traders, even those focused on the relatively low-risk covered call, all too often overlook the great advantages of the uncovered put.
This is not a high-risk strategy. The market risk is identical to that of the covered call. In this and the next three articles, the short put is analyzed and compared. This article focuses on the advantages of short puts. The next one talks about risks. Third is a discussion of collateral requirements and margin. And fourth is a detailed comparison to the covered call.
The first and most obvious advantage is that short puts generate cash. Selling an uncovered put creates a buffer between price and strike.
By selecting a strike well below current price level, you create an additional buffer. For example, the chart for Priceline (PCLN) reveals tremendous 300-point bullish move in the past six months.
This chart shows that price at above $2,205 per share was also trading close to upper Bollinger Band level, about 24 points away. Next, take a look at short put contracts to decide whether any opportunities can be found.
The most advantage is gained selling puts expiring one week away. On average, options expiring in one week lose 34% of time value between Friday and Monday. For example, an analysis of options on the Friday as of the day after of this chart show the price had declined more than 4 points, to $2,020.95. A short put contract could be opened with a 20-point buffer and attractive premium:
Expiration: August 4 (7 days)
Strike: 2,000 (20-point buffer below current price)
Premium: $1,030 (about $1,025 after trading costs
Total buffer on this trade combines 20 points distance from price to strike, plus 10 points received for the bid on this put. Total buffer: 30 points.
Remembering that one-week options tend to lose one-third of time value between Friday and Monday, without any move in the stock price, the short put could yield a profit over $300 in one treading day (Friday to Monday).
Do you take profits at that point? As a general rule of thumb, take profits in the double digits as soon as they appear. Don’t hold out for more, because those profits could evaporate as quickly as they appeared. Once profits are taken, look at options expiring the following week (in this example, August 11). Premium will be much greater, providing two benefits: Ability to set up a nice buffer zone, plus receiving a nice premium right away.
Looking only at the advantages of the short put, the reasons to pay attention to this rather than other strategies with similar risks, make it a viable strategy to study and perhaps to execute.
The next article in this series addresses the question of risks in the uncovered put.