A couple of the questions I see quite a bit from new subscribers are how they are supposed to know when to close a put selling trade I’ve written about, or how they are supposed to avoid buying the stock if it drops below their option’s strike price before expiration. I’d like to use today’s post to elaborate on these questions in more detail.
First, when I sell a put option to open a trade, I’m really looking for one of two results:
- The stock closes at expiration at or above the strike price of the put I’ve sold. In this case, the put option expires worthless. I don’t have to do anything to close the trade; I just keep the money I brought in when I sold the put and the option goes away.
- The stock closes at expiration below the strike price of the put I’ve sold, which triggers an automatic stock assignment. That means I’ll buy the stock at the strike price of the put I’ve sold.
If the stock closes below the strike price I’ve sold, I will initially be in a negative position, since the stock is lower than my purchase price.
Since the stock assignment in the second case is automatic, I also don’t have to take any additional action; my broker handles the transactional details, I pay the commission fee for the stock purchase, and the shares are now in my account. This is why I don’t write about closing the put selling trade. The put will either expire or I will be assigned the stock, and I’m okay with either result. When I am assigned a stock, I begin looking for opportunities to sell call options against it to generate more income and lower my cost basis in the stock. I like to sell out-of-the-money call options so that if I am called out, I can factor a capital gain into my profit analysis along with the income I’ve generated with the put sale and the covered calls. The covered call is the mechanism I use to “close” a stock position. My Tuesday highlights emphasize put selling first and foremost, but if I have been assigned a stock from one of my highlights and a new covered call opportunity comes along, you may see me write about it on either Tuesday or Thursday.
There is a common perception I’ve seen that thinks of put selling as a directional strategy, like buying a call – you’ll only sell a put if you think the stock will go up. The problem I have with this mindset is that it encourages you to think that a stock assignment from a put sale is something to be avoided. I get questions from time to time about why I don’t “roll” my put options from month to month when I’m “underwater” (a common term people seem to like to use when the stock is below the put option’s strike price, meaning that an assignment is likely) on the trade. The first answer is that I have no intention of avoiding a stock assignment; buying the stock actually gives me two ways to keep the income machine going, since not only can I look for opportunities to sell covered calls, but I’ll also be able to draw dividends on the stock if I own it through a dividend declaration.
The principle of “rolling” a naked option is something that I know a lot of income traders believe in, because the one thing they don’t want to do is to be forced to fulfill the obligation selling the option put them under. Keep in mind, however that deciding when you should buy it back is almost entirely about gut instinct; if you do it too far in advance of a contract’s expiration, you could see the stock reverse back and move above the strike price you sold later on, or possibly rebound enough to let the effect of time decay erode enough value to help you minimize the loss more. Either way, since the stock’s price will be below the strike price you sold, you will have to pay more and eat a loss on the trade.
An earlier put sale trade I placed on JBL in 2014 is a great example; I sold the April 1 20 put for $.63 per share. Shortly afterward, but before expiration, JBL had dropped a little below $18, which meant that I absolutely expected to be assigned the stock at $20 and be down (on paper) about $2 per share on the stock right out of the gate. I could have bought put back right away to close the trade and avoid the assignment, but doing that meant paying $2.30 per share and absorbing a loss of $1.67 per share, per contract. That puts the burden of making up for that loss on my next several income trades. It isn’t a given that will happen quickly; in my experience you can usually expect your next three to four trades, at least to be all about making up the difference, rather than on producing useful income. Of course, there is lots of evidence that doing exactly this, and maintaining the discipline to keep the process going, will still yield very attractive results, with the added benefit of increasing your trading frequency. That means your net returns should be higher than mine – but if you’re new to income generation, getting the hang of the discipline and process required may be difficult and discouraging.
I’ve written quite a bit in this blog about my belief that you should never sell a put option on a stock you are not willing to own. I’ve seen a lot of traders who think that if the stock drops below their put’s strike price, they would rather just buy the put back from the market, absorb the capital loss on that trade, and move on to the next one. Hopefully, I’ve already explained the transactional problems that creates, but you should not ignore the fact that closing the trade eliminates the possibility of capital gains in the stock once it starts to increase in value again. That means that a big component of my system, which relies on covered calls, is taken completely out of the picture. Over time, those covered calls trades have made up an important part of my overall success.
The difficulty, as many of you have seen, comes when the stock is several dollars below the strike price you were assigned at, and keeps dropping. Selling out of the money call options is going to help you lower your cost basis, sure – but the further the stock drops, the less likely you are to get any premium of real value from any strike price that is close to, much less above, that net cost. That means that to write a new covered call, you have to be willing to sell a lower strike price and run the risk of a reversal that could call you out of the trade before you’re really ready to. So what do you do?
My answer is actually pretty subjective: sometimes I’ll go ahead and write a covered call, and sometimes I don’t. While some parts of my decision-making process in this situation are based around analytics, others are based around nothing more than my gut instinct. I’ll give you a couple of examples from my historical trades to illustrate.
On November 18, 2014, I sold a put on SLCA with a strike price of $41 per share. The trade covered a month, and at expiration the stock was at $28.41. I was assigned the stock at $41 on December 19th; my net cost in the position at that point was $39.50 per share. The stock was still dropping almost in parallel with oil prices, and although the stock rallied a couple of dollars from a low around $23 in late December, it reversed again and started back down. On December 29, 2014, I sold a covered call for 18 days on my shares, this time with a strike price of $29. I was taking a risk at that point, but with the strength of the downward trend, and few signs of a recovery in oil led me to believe the stock wouldn’t be likely to get above that price. Turns out I was right – the stock found a low at $27.50 before reversing. The picture really only got worse from there – the stock dropped as low as $14 on multiple occasions before finally rebounding in summer 2016 – almost two years later – to approach my original purchase price. I sold a covered call on the stock at $41 in August 2016, and was called out of the position at that point. That allowed me close the trade at a net profit; but it required two years of patience and vigilance before it happened.
In December 2014, I sold two put contracts on SYNA. The first was on December 10th with a strike price of $62.50, and an expiration date only 9 days away. The stock closed on December 19th above $68, so this contract expired worthless. On the 23rd, I sold another put contract that expired on January 9th with a strike price of $67.50. The stock closed on the 9th below $61, so I was assigned the stock with a net cost of $65.65 ($67.50 – the $.85 premium) after the assignment. On the 12th, I sold a covered call to expire on January 22nd with a strike price of $62 – accepting the risk of being called out lower than my actual cost. At the time, the stock looked like its downward trend would continue, or at the very least the stock should hold somewhere between $58 and $62. Instead, it rallied higher, with strong momentum that from that point pushed it to new highs.
Now comes the really subjective part of this process I referred to earlier. A day before expiration, as I was looking at the stock and its current momentum I thought about my options. First, the stock was about $1 above my $62 strike price; I could wait to get called out and absorb a loss of $3.55 per share. Second, I could buy the call I sold back from the market. The call was priced at $4.40 on the Ask, while I sold it at $.90 to open the trade, so in terms of immediate loss, there was practically no difference, numerically speaking, to sway my decision one way or another. I would have about the same amount of loss in the near term either way. What did I do?
I bought the call back. Why? In looking at this stock’s activity over the prior few days, it seemed clear that other investors agreed with my fundamental opinion that SYNA’s price at that time was a bargain, so they wanted to get in while they could. The stock was also due to report earnings on the next Thursday after expiration, and it seemed clear to me that the market was betting on positive numbers. I decided to let the stock ride for a bit and see how it played out. In this case, the result was great – the stock went to nearly $80, where I wrote another covered call that I was not called out on, then finally called me out of a third covered call trade at $81. My net gain (premiums + capital gain) in the trade for holding a two-month position was more than 24%.
So, if I were to sum up my approach? First, I’ll never sell a put option on a stock that I’m not willing to own – even if the stock drops far below my option’s strike price. Once I’m assigned a stock from a put sale, I take a case-by-case approach for each position, since no two positions are going to behave in exactly the same way. I’ve had a number of other stocks over the last several months that were assigned to me when the put expired and gave me an opportunity to get out with very nice net profits on an exercise from the next month’s covered call. In those cases, the stock’s drop below my put’s strike price wasn’t nearly as deep. It’s really not possible to apply a single method to every single case, so you have to be willing to adapt. Remember that the focus for each position you establish is on income generation; trades that facilitate that process and might help make the occasional stock assignment more cost-efficient are embraced, while trades that help you avoid the obligation of an option sale are counter-productive and more, not less costly to the system in general.
If you are a new subscriber, please take some time to review the videos in the Getting Started area of the website. These will give you a pretty comprehensive view of the value-oriented approach I use to generate income with put selling and covered calls. You will also find it useful to read my Frequently Asked Questions article. Also feel free to review my previous posts as you’ll find additional answers to many of the questions you may have.