Here’s a simple option trading strategy for times when a stock you’d like to buy experiences a price downturn which you think is temporary and you’d like to be a contrarian and get long.
Instead of simply “buying the dip”, sell out of the money puts.
The beauty of the strategy is that even if you’re wrong about the direction of the stock price, you can still make money.
Using Implied Volatility to Work for You
The reason this trade can work so well is that when a stock goes down, the implied volatility of the options – especially puts – usually goes up.
It’s a well-known fact that stocks tend to fall more steeply than they rise. Bad news affects the price to the downside more than good news does to the upside. The magnitude and speed of downside moves tend to be greater.
Since traders are willing to pay more for options on a stock that is moving, or likely to move, they raise the volatility component in their pricing models, raising the price they are willing to pay for options.
In fact, the sophisticated options pricing models used by professional options market makers usually have this change in volatility built in. When the stock price declines, volatility inputs are automatically raised.
This means that in periods of high volatility, especially on moves to the downside, option sellers receive higher than normal premiums.
If you were thinking of buying the stock anyway, selling out of the money puts can be a less expensive way to go about it. If the stock continues to decline through the strike price of the put you sold, the option will end up in the money at expiration and you will be obligated to buy the stock at the strike price.
Your net price on the purchase will be the strike price minus the premium you collected on the sale. Because the put was out of the money when you sold it (it has a strike lower than the current stock price) your basis for the purchase will be lower than the market price for the stock was when you initiated the option trade – effectively a discount.
If the stock doesn’t decline below your strike price, your put will expire out of the money and you will keep the entire premium.
Obviously, there’s risk associated with this strategy because if the stock price continues to decline, you own it and will suffer losses. It’s the identical risk you assume whenever you buy a stock.
Lam Research (LCRX) is down $14.50 on changing outlooks about the semiconductor industry. You know that Lam is a Zacks Rank #1 (Strong Buy) and has a VGM score of B. You think the market reaction is overdone and want to become an investor at the current stock price of $189. Instead of simply buying the stock, you sell the 185 strike put expiring on May 18th at the current bid of $6.
If the stock is trading below $185 at expiration, your (now in the money) option will be assigned and you will purchase the stock for $185. Because you collected $6 in premium on the option sale, your basis price is $179, a more than 5% discount to the $189 you were going to pay.
If the stock doesn’t go any lower than $185 or rallies instead, you keep the whole $6. (Since standard options contracts are for 100 shares of stock, each expired put represents a profit of $600.)
Some notes on this trade:
Be careful about selling options right before or after quarterly earnings announcements in the stock. Implied volatilities (especially in short dated options) tend to rise going into a scheduled announcement because of the potential of a surprise beat or miss to move the stock quickly. Volatilities will then decline sharply after results are announced and any resulting move in the stock happens.
If you sell a put right before earnings, you’ll collect a high premium, but put yourself at risk of a big loss if the company misses and the stock declines.
If you sell a put right after earnings, the stock decline has likely already happened and the premium you receive will be much lower.
Risk and Margin
Because of the risk involved, brokerage houses generally require that you have available cash or margin in your account to complete the purchase of the stock in the event that the option ends in the money and you are assigned. Some houses may also require that you are experienced in trading and/or well capitalized before allowing you to execute a sale in an uncovered option. You will need to square this away before you trade.
Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.
Want more articles from this author? Scroll up to the top of this article and click the FOLLOW AUTHOR button to get an email each time a new article is published.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.