Selling put spreads. A new wrinkle

Mark,
I did a bull put spread- just 2 contracts.
Bought GILD 7/16/2011 38 P
Sold GILD 7/16/2011 40 P

This is the first put spread I have ever done. I’d like to make sure I understand it.
[MDW:This is something to do before you trade, but let's be certain that you understand NOW]

I own the 38 puts. So if the stock falls below 38 I can sell it.
[Yes. But remember that you bought it as protection to limit possible losses. You can sell that option any time before the close of trading on Jul 16, and the stock does not have to be below 38]

This lowers (limits) my potential loss on the spread to $2 per share if the stock plummets.
[The maximum value for that spread is $2. But don't forget to deduct the premium collected when selling the spread: Your potential loss is reduced by that premium]

I sold the 40 puts, so if the stock falls below 40 I am obligated to buy it. It is a bullish trade, so I am believing the stock will be above 40 by the expiration date.
[I know what you mean, but for clarity, it is not 'by' the expiration date that matters. It is 'at expiration,' or the closing price on the 3rd Friday of July. That closing price determines whether the put owner will exercise and force you to honor that obligation.]

If the stock is above 40 at expiration the puts expire worthless and I keep the credit I received (net credit 38 cents per share).
[Yes. That cash is already in your account. And it is yours to keep NO MATTER WHAT HAPPENS. You may decide to spend some cash to repurchase the puts (I know you won't, but theoretically speaking). But that 38 cents is no longer relevant. It is yours forever]

If the stock is between 38 and 40 the 38s will expire worthless and I will be assigned the stock. That is fine, I am getting it at a reduced price and I like the stock; OR CAN I SELL TO CLOSE THE 38s?
[The price reduction is ONLY the 38 cents credit collected earlier. That’s not much of a price reduction.

[You may sell the 38s at any time before the market closes on that 3rd Friday, if anyone is willing to pay something to buy them]

[With your emphasis on selling the 38 puts, I believe you are adding a new wrinkle to spread trading - keeping the shares. That's worthy of further discussion - keep reading]

If the stock is below 38 what is best strategy? Since I like the stock I should allow the stock to be assigned to me, and then sell the 38 puts to close (before expiration).
['Best' is not easy to define. In your scenario - keeping the shares, then selling the puts is a very unusual choice because the vast majority of those who trade put spreads have no interest in owning (or selling short) stock. They trade spreads with the intention of earning a profit. There is seldom an interest in owning shares. Thus, the question remains: why did you buy the 38s?]

    This reply arrived via e-mail:
    This is a bit of a hybrid. Given that I am willing to own stock, doesn’t owning the 38 puts provide some protection? Also, if the stock is below 38 near expiration, the 38 puts have value and I could sell them, thus reducing my cost basis for buying the stock?

[Yes. You are correct. Owning the puts provides protection – for a limited time. But that protection is NOT cheap.

Yes again. Selling those puts lowers the cost basis. However, not buying the puts in the first place lowers your cost basis even more (except when the stock moves well under 38) on those occasions when you do buy the shares via being assigned an exercise notice.

Traders who sell naked puts – don’t seek only that short-term trading profit. They are willing to own the shares at a better price (when compared with the stock price at the time the puts were sold) – and almost never buy protection.

You are doing both. You want to own the shares and you prefer to own protection. There is nothing wrong with that. I believe it is always a good idea to limit losses.

However, you are new to options and I want to be certain that you recognize the cost of owning puts as protection. Bottom line: It is expensive. The big question – and perhaps it’s something you have not yet considered – is: What are you going to do for protection after July expiration?


Example: If you own 100 shares and buy one 38 put (two month lifetime), paying $1, then the stock price must rise by more than $1 before you earn any profits. If you buy those puts every other month, then the stock must rise by $6 or 15% every year for you to overcome the cost of the put protection. It’s not so easy to find stocks that rise 15% per year, and when an investor does that, he/she deserves to make some money, not spend that 15% on insurance.


[This is not the place for details, but if you own stock plus puts, that is
equivalent to owning calls - with the same strike and expiry as the puts.] Do you truly want to own calls rather than stock? The answer should (in my opinion) be NO, unless the calls are significantly in the money.

997


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