Short Put Option strategy
In this blog, I am hoping to convince you as to the merits of the short put option strategy around earnings. I am going to share a recent example of a trade that I did with Fedex that yielded a $38.25 profit after 1 day even though the share price of Fedex fell!
What is the short put option strategy?
The short put option strategy is when you insure (sell a put option) the value of some other investors’ shares for a fixed price (premium) for a fixed period of time (expiry date). You get paid a ‘premium’ for insuring these shares. You can buy yourself out of the insurance premium at any stage by buying back the short put options that you sold. The best way to explain is using an example:
Fedex Earnings Trade
Look at the chart of Fedex below:
On the 20th December 2016, Fedex was trading at $196.60. They were about to report their earnings that evening. When a company reports earnings, they are announcing their results for the previous 3 months for sales, profits etc…. Stocks can rise or fall substantially after earnings which creates volatility.
I did my fundamental analysis on Fedex and decided that if the share price fell to $175 after earnings, I would be happy to buy or manage the stock at $175. I decided to use the short put option strategy.
The Jan 20th $175 put options
I looked at the put option quotes expirying on Jan 20th and noticed that I could sell the $175 put option and receive $0.89 per share in premium. I decided to go ahead with the trade and insure the value of 100 shares of Fedex for $175.
I received a total premium of $87 [$89 (100*$0.89) minus $2.00 in trading commissions]. This premium goes into my trading account under ‘cash’. I then hold a Fedex Jan 20th $175 short put position.
The buyer of the Fedex jan 20th $175 put option has the right to sell his/her Fedex shares to me at $175 at any stage between now and the Jan 20th expiry for $175. This means that I have an obligation to follow through on my end of the bargain.
The buyer will only exercise their rights if the share price of Fedex falls below the $175 price level. Above $175, it is not financially rewarding to the put option buyer to sell the shares at $175. In this scenario the put option will simply expire worthless. I keep the cash they gave me for selling them the put option.
Breakeven, leeway and probability of profit
As I mentioned already, I insured the value of Fedex for $175 and received a net $0.87 per share (after trading costs). This means that my break-even on the trade was $174.13. In other words, the share price of Fedex could have fallen to $174.13 before I start to make a loss at expiry.
Because the price of Fedex was $196.60 when I placed the trade it meant that Fedex could have fallen 11.43% to $174.13 before I start to make a loss. This is why this trade had a very high probability of profit. In fact, I had a 94% probability of profit with this trade.
A word on implied Volatility
A key component of put option prices is implied volatility. The higher the implied volatility, the higher the premium you can get when you sell the put option. Take a look at the chart of implied volatility below:
You can see that before the earnings announcement that implied volatility was high and then it fell the day after earnings. The reason for this is that the earnings announcement which can cause uncertainty was over. The effect of this reduction in implied volatility allows me to buy back the short put options cheaper than what I sold them for the previous day (assuming the share price hasn’t fallen too much).
Closing the Trade
In fact, the day after earnings, the share price of Fedex fell to $194.36. I bought back the Fedex Jan 20th $175 put option for $0.48 per share ($0.41 per share cheaper than what I sold it for). This netted me a profit of $38.25 (after costs) in 1 day.
Our obligation is removed
The great thing about options is that they trade like stocks, you can buy and sell in a matter of minutes if you wish. This means that in the Fedex example, I could close the $175 put option at any stage. When I bought back the put option I removed my obligation to buy the Fedex shares and I simply kept the profit.
A word on risk and margin
Although this was a high probability trade on a stock that I was comfortable owning, I was committing myself to purchasing 100 shares of Fedex at $175 which is a substantial investment of $17,500. If Fedex fell substantially after earnings, I could have faced a large loss on this position. Buy my counter argument is that I would have even larger risk if i bought the shares outright at the beginning. Also, the likelihood of the share price of Fedex going to $0 is remote.
In fact, if you trade options, your broker will not ask you to have the $17,500 of capital committed. They will simply ask you to margin the position or deposit assets to a certain value. In this trade my margin was only $1,771. This meant that I only had to set aside $1,771 of capital to maintain this position. Please note that margin is not a fixed amount, margin can rise and fall as the position goes for or against you. For example, if the position moves against us the margin requirement will increase and vice versa.
Return on Margin
In the Fedex example, my return on risk is best measured by return on margin, It is calculated by divided the profit by the margin amount and multiplying by 100.
Return on Margin = (Profit/Margin)*100
= ($38.25/$1,771) * 100
= 2.16% in 1 day.
Not bad for one day and considering my profit probability was 94%. Option trading is less risky than trading stocks or currencies when you know what you are doing!
You can learn more about these option trading strategies in the members area of our website and through our live classes.
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- All training
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I hope you enjoyed the blog.