How I Manage a Put Option — Part 1
This is the first part in a series of posts discussing how I manage a put option. Today’s post discusses what a put option is and several of the factors that work into determining how the premium is determined.
When you sell a put option there’s only three things that can happen: 1) It can either expire worthless and you get to keep all the premium, 2) it can be in-the-money when the put expires and you’ll be assigned shares, or 3) you can choose to buy back the option either for a profit or a loss.
There’s nothing wrong with any of these options. In fact, you should only sell a put option on a stock and a price you would not mind owning it at.
Here is a simple example: I want to buy a stock but not at the current price. So I sell a put option at a strike price that I want to buy it at and get paid money (a premium) to do this. Pretty cool, huh? Basically what I’m doing is acting as an insurance company for someone else. If the stock drops below my strike price then that person can use his insurance and sell it to me at the strike price. There’s really no loser in this arrangement. I’m getting to buy it at the price I want and the buyer of my option sells it at the price he wants.
However, there are a few things that can happen that you may grumble about. One of these is if the stock drops way below your strike price. This means that the option is now “in-the-money” and you could at any point be assigned those shares. (By assigned I mean forced to buy 100 shares at your agreed upon strike price.) It would not be fun to buy a stock substantially lower than market price but, hey, that’s the risk you took and why you were able to collect that premium in the first place…others’ insurance in case the stock dropped like this. Most likely even for a deep in-the-money option, the option buyer would wait until expiration to sell you those shares. This cannot be guaranteed, however.
So if put options by themselves are fairly straightforward, what determines option pricing then?
In general an option works like this: The option has both an intrinsic and extrinsic value. The intrinsic value is easy to determine; it is just the difference between the strike price and the current stock price. If I was going to give you the option to buy something at $75 and the stock price is $77, I would want to get $2 additional from you (per contract) since I’d otherwise just opt to sell it on the open market for the higher price. However, an option is traded not only with a strike price but also with a time component. It is this time component that factors into the extrinsic value of an option and why the premium of that $75 strike price above is more than $2. As the option nears expiry, the extrinsic value drops to zero.
How much more than $2 is hard to determine. It is a factor of the length of time until expiration and the stock’s volatility. There’s a thing called implied volatility that is a huge component. Essentially premiums are higher for more volatile stocks and generally ticks upwards prior to a company’s earnings…any uncertainty raises volatility. Volatility is directly related to premium.
When I sell a put option I sell it out-of-the-money so all that I’m collecting in premium is in extrinsic value. When the option expires there is no longer any extrinsic value and the intrinsic value remains zero. For puts this means that you pick a strike price below the current stock price. The stock would have to drop to below your strike price for it to have intrinsic value. When you sell an option below the current stock price or the stock price drops below the strike price the premium increases substantially since it now not only has whatever remains of the extrinsic value but now also has an intrinsic value, the difference between the strike and the current stock price.
As sellers of options we generally want to deal with higher volatility stocks since we get more premium this way.
Options traders also talk a lot about the “Greeks,” no not the philosophers but the Greek letters that have been assigned to option jargon. The main one that I want to concentrate on is theta and the phrase “theta decay.” This refers to the daily decline of the extrinsic value of an option. Assuming implied volatility and price movement are held constant, the extrinsic value would lose a certain amount each day so that by the time option expiration came around the extrinsic component would be zero.
Theta decay works in the seller’s favor. It basically means that if things stay fairly constant a put option would lose value in a predictable way.
So how can we use this to our advantage? There’s an interplay between premium that you can collect and theta decay. For an option expiring in a few days the theta decay is huge since the extrinsic value (the uncertainty) will be zero when the option expires. For an option that expires a long ways out, things get a little more complicated. There may be more volatility since the stock could make big moves between now and then and news could pop up that is not currently factored in. But, theta decay is less. So if the implied volatility and stock price stay relatively stationary, the amount of daily theta decay is much less than for an option with less time until expiration.
The guys and gals at tastytrade put together a video showing that selling options in the 35-50 day range give the best value of premium and theta decay. Essentially their research shows premium will drop to around 50% about halfway into the 35-50 day timeframe. In their experience buying back an option makes sense when you have locked in at least a 50% profit.
Next up in the series is a real life example of how I have been managing a put option on GILD.
Anything that needs more clarification? Let me know in the comments below and hopefully I’ll be able to help.