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When selling puts, have an exit plan

Chris McKhann (chris.mckhann@optionmonster.com)

As volatility dropped recently, traders continue to sell puts . And depending on their goals, retail traders tend to use credit spreads instead of naked shorts, but either case can create some important issues in exiting or adjusting positions.

The idea of selling naked options makes most retail traders' skin crawl. But of course the position is essentially the same as a covered call , which is the most widely used option strategy. We have covered that topic extensively in the past, but institutions have been selling puts in droves recently, so it is worth exploring once more.

Institutional traders sell puts for two reasons. The first is that puts are often overpriced, in terms of the realized volatility that comes to pass, so selling them provides a relatively high probability of profit. The second is that they sell puts to buy stock , as the trade obligates the seller to buy the underlying shares if the price is below the strike at expiration.

This means that traders can effectively get paid to buy stock, and do so with less risk than buying the shares outright.

AVP tradeLAB

Take, for example, the put selling we saw in Avon recently. A trader sold almost 9,000 November 33 puts for $0.95 as shares of AVP popped to $34.57. So in the first case, the trade gets to keep that credit of the premium as long as AVP remains above $33 through expiration. That is a much higher-probability bet than simply buying the shares.

And if stock is below $33 at expiration the trader will be required to buy the shares, but effectively for $32.05. That is a 6 percent discount to the then-current price, so it is lower risk than just buying the same number of shares outright.

Now most retail traders aren't interested in buying the shares, instead using puts just to collect overpriced premiums. To reduce risk they use credit spreads, selling a put and buying one that is further out of the money to reduce possible downside risk. This structure makes sense but creates issues for exiting and adjusting.

For outright put sellers, however, the fact that they are willing to buy the stock at the strike makes adjustments largely unnecessary. They are getting paid and, if assigned, they own the stock--end of story. If the stock really tanks, they can sell shares against the position or buy other puts to hedge the position.

But those who sell credit spreads usually do so out of the money and therefore have a high probability of profit but an unfavorable risk/reward ratio. In the case of AVP, a trader might sell the November 32 puts for $0.65 and buy the November 31 puts for $0.45, taking in the credit of $0.20.

The so-called deltas of the options--which tells us the probability of those options expiring in the money--are 0.22 and 0.15 respectively. This means that the trade has a 78 percent probability of a full profit and and just a 15 percent probability of a full loss. (See our Education section)

So while the probability is only 15 percent, the trade will lose $0.80 if AVP is below $31. That means that, if you are right four months in a row and wrong one, you have nothing to show for it--except for your losses through commissions and fees. So the put credit spread needs to be closed before it can take such a loss.

Many traders suggest adjustments, but for the most part I believe in admitting when I am wrong and moving on. I would typically do that if the spread moves from $0.20 to $0.50. On larger spreads I would exit if it moved to twice my credit. With smaller spreads, the bid/ask difference makes up a big portion of that.

Credit spreads on one side of the market are not usually my preferred trade. Iron condors, which involve selling put spreads below and call spreads above the market, increase the probability of making profits. But adjustments and exiting are still the biggest issues for iron condors, and different people have different rules.

The key is to have rules, ones that make sense from the standpoint of trading and that actual work in the real world.

(A version of this article appeared in optionMONSTER's Open Order newsletter of Oct. 13 . Graphic courtesy of tradeMONSTER .)