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Advanced Options Trading - Puts, the Sweet Spot, and Other things

Filed Under Advanced Options Trading 

Puts, the Sweet Spot, and Other things
 
 Let’s say you decided that you wanted to buy XYZ at a $40 but unfortunately it’s trading now at $50. XYZ is at $50; it’s running up, but if it ever came back down to $40 you’d love to buy it. Ok, here is one way to position yourself; you’re going to sell an out-of-the-money $40 put for XYZ  and if the stock ever trades lower than $40 during the option period, then you’re going to own it as more than likely somebody will exercise their rights as the buyer of the put and place the stock with you-the seller. If the stock doesn’t reach $40, no big deal, you’re going to keep the entire premium from the put, a win, win situation, right?
 
That might be good for some stocks that are volatile but the real world may turn out to be different when you do get the stock when it hits $40. You see, something happened to make the stock move down $10 from $50 and that $40 strike price may just be another tick on the way down to some undefined bottom. In other words, why not just wait until you have an idea of where the bottom might be. So, this strategy of selling a put to buy on the cheap and collect a credit in the process may be more risky than you think.
 
Puts in Stock Replacement
 
Some brokerages have rules that prohibit clients from shorting stock. Other brokerages charge such a high margin for going short that it discourages most traders.  But, alas, you can buy a put and solve both of those problems. You see, you can use puts as a stock replacement strategy trade, which replaces a short stock position.
 
Most traders have a pre-disposition to concentrate on making money on the way up. Few realize that they can double the amount of potential winning trades by being open to making money on the way down. Part of the tunnel vision is from the broker restrictions on shorting stocks; in other words, if you can’t do it, why learn about it?
The truth is that traders are passing up a huge opportunity to play both sides of the market. But with puts, no problemo, you can be right there by using a stock replace-ment strategy.
 
When looking for shorting opportunities, you use the same philosophy that you would use with shorting stock. You are looking for a break down technically or fundamentally-usually a combination of both. You identify your entry point and your protective stop. You establish a potential profit target but before you call your broker or click on the trade, you turn to a put purchase. You don’t short the stock but instead you purchase a put. As a matter of fact, puts are not only much cheaper than shorting the stock but also provides a defined maximum risk-the cost of the premium for the option contracts. However, you need to pick the right put to buy.
 
As we are using puts as a surrogate for being short stock, we want a put that will closely match the movement of the underlying stock. What we want is an in-the-money put with lots of Delta and not a lot of Vega, Theta or Gamma. We want an option that will mimic the movement of the stock and that means “hard” Delta.
 
Finding the Sweet Spot
 
When looking for the best in-the-money strike to buy, you need to find a strike that is not too deep in-the-money, which would be more expensive but not too close to at-the-money, which still has extrinsic value that evaporates away every day. So, you look for a strike contract that will have a Delta in the range of 80 to 85. That means that if the stock moves down $1, the option will move down 80-85 cents. In this way, you are- in affect- replacing the stock with options that mimic most of the movement of the stock. This strategy is much less expensive and with limited, defined risk.
 

For information on all things stock option, contact the Options University at www.optionsuniversity.com

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