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23 Nov MailBag – Covered Puts, option strategy

I recently received this question from one of my members. I think that there are some valuable lessons here on Options Assignment, Selling Premium and Margin.

Here is the question:

Hello Derek,

I have a question about trading short covered Puts. I must have the concept totally wrong. I own a lot of Ford stock. My basis cost 15.54, very near what F closed on Friday 11/21/2014..15.43. What would happen if I  sold 50 F (Weekly) Nov 28 2014 16.5 Puts? Is this what would happen?

1. My margin account would be credited a sale premium of approx. $4,000 Since I own 5,000 shares of F would selling the Put require credit over and above my share holdings?

2. Should I expect that the option(s) will be exercised before the option expires.."like immediately"?

3. Meaning all of my 5000 shares will liquidate probably immediately..."is that correct"?

4. Lets say market at exercise (immediately) is 15.43.

5. My margin account would immediately be credited 15.43 X 5000 minus commissions is that correct? Approx. $77,110  Plus..I keep the premium minus commissions. Is this correct? Approx. $4,000. For a total credit to my account of approx. $81,150?

What am I not understanding about doing this Short covered Put? Why would anyone not want to do this??

Where is the negative side to this trade? I have got to be misunderstanding something what is it?

 

Here is my response:

The terminology of "covered" means that you are offsetting the directional nature of one position with another position which works in the opposite direction - So for a Put to be "covered", you would need to have 5000 shares short against the sold put; this would negate the directional nature of the short put and leave you protected to the downside.

In your example, since you are selling a deep in-the-money put, there would not be any premium in the contract - in fact, I think it probably would be negative premium, so the only thing you are selling is intrinsic value - meaning that there would be no "buffer" between the strike price and where it would be exercised. So you would be essentially getting assigned (if you are lucky) for the exact amount you could buy it on the open market. The problem lies with the fact that when you sell it, you are locking in the amount you collect, yet the price keeps fluctuating while you are holding the contract (if this makes sense).

Also, remember with puts, you are assigned common stock, so you would be assigned an additional 5000 when exercised - the only "liquidation" that would happen is if you sold the put and it went against you and your margin ran out - and your broker would give you a margin call or maybe a "real time" liquidation of certain positions (I think Interactive Brokers does this).

Anytime you sell a short put uncovered, additional margin would be needed not only to cover the assignment of the stock, but also to cover any potential losses your broker might incur (most brokers do a percentage analysis - they say "how much money would this guy lose if this position fell 25%, 50%, etc " then they calculate the margin based on this and other factors).

Also, the way assignment generally works is that your contract is put in a queue, to be exercised when the exchange is ready, not necessarily immediately, and most likely the end of the day - so the price of the underlying could fluctuate a lot before it is actually exercised (added risk).

In my opinion, the greatest advantage to option trading is being able to collect out-of-the-money premium in order to leverage this collected premium to your advantage in other positions. For example, if I had a basis of 15.54 in F stock and wanted to acquire more, I would maybe sell 14 put out in Feb for .30 and collect the premium which would give me a basis on my new set of shares of 13.70 if assigned. The idea is if I already own some at 15.54, I would be thrilled to own more at 13.70. Warning though: this is not a "set and forget" type of trade, but one that needs to be managed if it goes against you; i.e., rolling the put down and out in time if needed.

Hope this helps.

 

 

 

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