4

http://www.google.com/finance/option_chain?q=NYSE:BBY

If I sell a Put at a $28 strike price, I'll earn $0.26/share (times 100 for one contract) = $26 today, correct? And as long as BBY doesn't drop to $28 by June 18, I keep the money. If it drops to $28, then I have to purchase 100 shares at $28/share, is that all correct? Now theoretically, if that happens, I can flip it RIGHT back and sell to the market at whatever the spread is and simply lose on that (plus commission).

Do I have that all right??

  • 2
    When you are forced to buy the shares at $28 from the option buyer who is exercising the put, the market value of the underlying shares can be well below $28 at that time. They won't necessarily exercise when the shares are at $28! – Chris W. Rea Jun 3 '11 at 23:24
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Yes. You got it right. If BBY has issues and drops to say, $20, as the put buyer, I force you to take my 100 shares for $2800, but they are worth $2000, and you lost $800 for the sake of making $28.

The truth is, the commissions also wipe out the motive for trades like yours, even a $5 cost is $10 out of the $28 you are trying to pocket. You may 'win' 10 of these trades in a row, then one bad one wipes you out.

  • If BBY drops to $26, can't I buy a Put to cover? – Shamoon Jun 3 '11 at 21:22
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    No. The opening trade was a gap down to $20. It closed on friday at $30, but over the weekend bad news came out, and opened Monday at $20, no chance to buy those $28 puts. (Please, don't think this is a joke. Individual stocks opening down 30% isn't uncommon. Making pennies by risking huge dollars is a recipe for disaster. There's a guy on the other side, happy to put his money down for a 25 to 1 payout. – JoeTaxpayer Jun 3 '11 at 23:16
3

The time when you might want to do this is if you think BBY is undervalued already. If you'd be happy buying the stock now, you'd be happy buying it lower (at the strike price of the put option you sold). If the stock doesn't go down, you win. If it does, you still win, because you get the stock at the strike price.

If I recall correctly Warren Buffett did this with Coca-Cola. But that's Warren Buffett.

  • You get the stock at the strike price, plus you get a premium from the option sale. – fennec Jun 4 '11 at 15:15
  • You are correct, MB, but selling puts is hardly a bull play. If I think a stock will rise, I buy the stock or buy calls, selling puts only to get stuck with a stock at an inflated price is a tough deal. – JoeTaxpayer Jun 5 '11 at 20:33
2

Yes, theoretically you can flip the shares you agreed to buy and make a profit, but you're banking on the market behaving in some very precise and potentially unlikely ways. In practice it's very tricky for you to successfully navigate paying arbitrarily more for a stock than it's currently listed for, and selling it back again for enough to cover the difference. Yes, the price could drop to $28, but it could just as easily drop to $27.73 (or further) and now you're hurting, before even taking into account the potentially hefty commissions involved.

Another way to think about it is to recognize that an option transaction is a bet; the buyer is betting a small amount of money that a stock will move in the direction they expect, the seller is betting a large amount of money that the same stock will not. One of you has to lose. And unless you've some reason to be solidly confident in your predictive powers the loser, long term, is quite likely to be you.


Now that said, it is possible (particularly when selling puts) to create win-win scenarios for yourself, where you're betting one direction, but you'd be perfectly happy with the alternative(s).

Here's an example. Suppose, unrelated to the option chain, you've come to the conclusion that you'd be happy paying $28 for BBY. It's currently (June 2011) at ~$31, so you can't buy it on the open market for a price you'd be happy with. But you could sell a $28 put, promising to buy it at that price should someone want to sell it (presumably, because the price is now below $28).

Either the put expires worthless and you pocket a few bucks and you're basically no worse off because the stock is still overpriced by your estimates, or the option is executed, and you receive 100 shares of BBY at a price you previously decided you were willing to pay. Even if the list price is now lower, long term you expect the stock to be worth more than $28. Conceptually, this makes selling a put very similar to being paid to place a limit order to buy the stock itself.

Of course, you could be wrong in your estimate (too low, and you now have a position that might not become profitable; too high, and you never get in and instead just watch the stock gain in value), but that is not unique to options - if you're bad at estimating value (which is not to be confused with predicting price movement) you're doomed just about whatever you do.

  • ... that last sentence is precisely why working with individual stocks can be high risk unless you invest serious time in researching them. There's a reason index funds are so highly recommended for folks who don't want to make that effort. – keshlam Sep 17 '14 at 12:48

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