Option strategies are just another investment vehicle, while they can be used to cover or leverage our portfolio many times fold, by default using options has no no more risk than buying or selling shares of stock, actually quite the opposite: Once used correctly, risk can be entirely set to a certain number or taken out of the table entirely.
For a more complete definition of options and specifically PUT options you can check Investopedia, they definitely do a great job explaining its intricacies, I’ll go through the basics of selling a PUT in Interactive Brokers, step by step:
When you’re selling a PUT contract you’re basically acting as an insurance company: You’re insuring someone else that you’ll buy their stock if the price reaches X, up to certain date limit, and they will pay us a fee in exchange of this agreement. Everything agreed upon. Price, expiration, and risk of the operation is known before agreeing.
Now let’s imagine that I want to have a company in my portfolio, but I don’t want to buy the stock at the current price for whatever reason, I may believe it’s currently overpriced, or a pullback is coming soon and I want to be ready to grab the stock if happens, or maybe I just prefer to stay in cash so I can use my capital faster. By selling a PUT on a stock, I’m assuring myself an entry price in the future ( if this happens ), and in the meanwhile, if doesn’t happen, I’ll get paid a fee for waiting rather than having my cash generating 0 return.
The first thing we must know is that a contract contains 100 shares, this means that each PUT or CALL agreement or contract contains 100 shares of stock. If a Tesla share costs $600, 1 PUT contract will have an underlying of $60.000 of stock.
The second thing we have to know is about the expiration date: There’s two type of options, European and American ones. While European ones can only be closed on expiration date, American ones can be exercised at any time until expiration. 99.9% of retail investors trade American options.
Real case scenario: Selling a PUT for The GEO Group, Inc.
*Disclaimer: This case was originally written on August 2020 in Spanish here, since then all predictions we took into account when entering the trade for $GEO were 100% correct.
As everything investment-related, more risk generally implies more potential of profit. In options trading we can easily check the risk/profit potential of a stock by taking a quick look to the Implied Volatility. Generally more IV means more implied volatility for that specific stock, and more premium (money) we’ll receive if we enter that position, but also more risk to be assigned with the underlying stock ( which is not a problem if you want to get assigned ).
In this case, the The GEO Group has a high IV not only because the business itself but also externalities like the political one that comes with private prisons:
The GEO Group (NYSE: GEO) is the first fully integrated equity real estate investment trust specializing in the design, financing, development, and operation of secure facilities, processing centers, and community reentry centers in the United States, Australia, South Africa, and the United Kingdom. GEO is a leading provider of enhanced in-custody rehabilitation, post-release support, electronic monitoring, and community-based programs. GEO’s worldwide operations include the ownership and/or management of 123 facilities totaling approximately 93,000 beds, including projects under development, with a workforce of approximately 23,000 professionals.
Let’s say it’s August 2020 now ( like in the original article ) and I want to buy 100 shares of GEO, but the dividend and EEUU elections are coming soon, and I’m a bit uneasy about buying them at this price right now. Caveats:
- While the dividend is pretty high (~10%) this is clearly not sustainable long term, not with their current debt. I believe they will pay in September same as previous years but most likely this will be reduced or eliminated in the future.
- There’s a certain political danger depending who wins the American Elections on November 2020, as one party is pro private prisons, and the other is not. As this company depends greatly on government contracts, is something we have to take into account.
- Is currently priced at $11, but I would feel more comfortable buying them at $10 or below.
Taking into account everything above, let’s say I don’t want my contracts to expire after October because I could be assigned the contract just after the owner of the shares has received the dividend, so I would lose the dividend, and receive the shares at a lower price.
I don’ want these to expire on November either because there’s a high volatility due to the EEUU elections, this could go to the moon or to hell in one day, so being conservative with my money I would prefer to stay out during this time.
Knowing this, September seems my preferable date of expiration. Let’s go to Google Finance, under Options, I check for PUTS and September dates:
The strike price (in the middle) will be the price of the share, the PUTS to the right will be the info about the contract, for example a PUT for $GEO at 18 Sept 2020 is paying around $0.25 per share.
Remember that 1 contract is 100 shares, so we would receive $25 in our account if we choose to accept this agreement ( sell this PUT ).
What happens next?
- I get $25 in my account, and $975 are hold as collateral until September 18th, 2020 ( or until the contract is closed from our end or the other party ).
- Case 1 – The stock goes up: If $GEO remains above $9.75 by September 18th, 2020 (That’s the strike price minus the premium received: $10 – $0.25 = $9.75), I will keep the $25, and the $975 will be freed from hold. In this case we’ve earned a 2.5% return in 30 days, and we have no shares.
- Case 2 – The stock goes down: If $GEO goes below $9.75 by September 18th, 2020, I will keep the $25 and the $975 that were hold as collateral may be used to purchase 100 shares of stock. In this case we’ve acquired 100 shares of $GEO at a price of $9.75
In the “Order Preview” screen we’ll see various details, for example the Bid/Ask price for the premium. This is between 0.20 and 0.30, so we’ll take the middle point of 0.25 to assure that the order will go through.
The collateral will appear as Initial Margin (in my screen this show in Euro, that’s why there’s a discrepancy with the $GEO price in USD), and you’ll see a Position -1 on this stock. This is because you have a passive in your portfolio, that’s the obligation to purchase this contract at expiration if needed.
We click “transmit” and if the order is executed we’ll receive this message:
SOLD 1 GEO Sep18’20 10 PUT @ 0.25
Now we only have to wait until expiration, however there’s multiple things we could also do in the meanwhile, for example close the trade by re-purchasing the PUT, rolling the agreement to a future date, rolling it to a different strike price (up or down), etc, … but we’ll leave this for future posts.
This was a very basic introduction to how to sell a PUT using Interactive Brokers. I hope you liked it! Feel free to drop a comment below if something is unclear, or for anything else 🙂