Updated: Aug 6, 2019
Option selling strategies are a great way to lower our breakeven level and create a substantially higher rate of investment success. Being an ordinary shareholder involves buying stock and hoping for a happy outcome. Selling out-of-the-money puts means we can figure out what our breakeven level is (strike minus total premium received). The more conservative you are, the lower the premium and breakeven level will be.
But what if the trade starts turning against us? Is there a way we can navigate through adverse situations to mitigate losses or secure a nice return? One of the key indicators is to take a look at your break-even level as it relates to the price of the stock at any point in time.
Let's take a look at an example with NTAP.
Adjusted for dividends, shares were trading at $58.50 on December 18, 2017.
Sell the out-of-the-money put with a strike price of $56 expiring on January 19, 2018 for $2.00
This translates into the following trade:
Now, the stock starts to decline and drops below $56.26, a level which is 3% below the strike price, namely $55.32 on January 2, 2018. We use our 'Rolling down' exit strategy when the price dips below our breakeven and is at least 3% below the strike price. The cost to buyback the current short put is $3.10 and by selling the $54 we will generate $0.52. What does that imply for our trade?
Let's feed that information into my calculator (available for premium members only) which will do all the leg work for us:
The option we sold initially now consists of 121% time value. Why is that? There's a quite simple answer to that question I have to admit. When we sell an out-of-the-money put, the amount of time value will increase when the option becomes an at-the-money put where the chances of that option being in-the-money are precisely 50%. Let me give you some color on how this works by showing you the following graphs containing normal distribution definitions.
The purple/blue line represents the probability that something is going to happen. In case of options, the highest value will be reached when we're talking about at-the-money options, because there's a 50% chance that the option will either expire worthless or will expire in-the-money. In this article, we are dealing with puts. Now, when you take the left part of the chart and the right part of the chart, you'll notice that the purple line has the same 'height', although we're talking about two strikes that differ heavily from each other. In the example described above, we sold an out-of-the-money put which then became more at-the-money. As a result, the chances of that option being in the money increased and thus the time value component. In other words, the option we sold reacted significantly to a changing share price. That's also known as delta, which is one of the Greeks option trader examine before entering their trades.
Stated differently, although the option we sold is now slightly in-the-money, it still has lots of time value attached to it, making it very expensive to exit our position. Even more important, our trade remained profitable! So why would we take the risk of exiting a position that's currently paying an annualized return of 27%? It's simply not to our advantage to quit our position. Should the price start to drop below $54, our breakeven level, we can take action. Yet, time value will have eroded the option value and thus made it cheaper for us to get rid of our short puts.
If you want to quit your trade, your loss would be 1.97% and you would miss out on a time value return of 4.32% because the option has become more or less at-the-money. So, it's weighing the pros and cons of either rolling down or exiting our positions in order to revert dead money to cash profits...
Being conservative with our strike price selection will elevate our chances of trading consistently profitably. However, sometimes even after having screened for the best stocks trades may start to turn out adversely. In those cases, we have to implement our exit strategy arsenal to mitigate losses, improve gains and throw the odds of an attractive risk/reward profile into our favor.
My guideline is to roll down when there's no technical breakdown, when we are 3% below the strike price. When we drop 2% below our breakeven, we need to carefully consider whether we still want to be exposed to an underperforming stock.