Stock traders and investors often enter orders to buy shares at a price that’s lower than the prevailing price. But did you know that certain options strategies can be used to pursue the same objective?
By selling put options, some options traders use strike prices as potential stock entry points. Remember, if you sell a put and the stock falls below the strike on or before expiration, you'll likely be assigned, meaning you’ll be buying shares of the stock at the strike price. And, really, early assignment is possible any time the stock drops below the strike prior to expiration. For more on the basics of calls and puts, please refer to this primer.
One of the main risks of selling options is the open-ended risk—a stock can fall all the way to zero and can rise, theoretically anyway, to infinity. So if you’re interested in putting a limit on your risk, you might choose a defined-risk strategy such as selling a put spread. But before you consider this strategy, it’s important to understand the mechanics, as well as the risks, of selling put spreads to potentially buy stock.
Here’s an Example
Let’s say a stock recently rallied above a technical resistance level at $90 and is currently trading at $100. Some chart watchers might now see that $90 level as an area of possible support, and thus a possible entry level. If you’re an options trader who’s interested in buying the stock at $90, you might decide to sell a put spread where the short put has a strike price of $90. Consider the example option chain below.
|Call Bid||Call Ask||Strike||Put Bid||Put Ask|
TABLE 1: THEORETICAL OPTION VALUES. Put option prices for options with the underlying stock at $100. For illustrative purposes only.
Defining the Risk with a Put Spread
Being short the 90 put means you’re taking on the potential obligation to buy the stock at $90, which is, initially anyway, your objective behind this trade idea. However, your opinion of the stock might change if you wake up to find the stock trading at $70 or lower. This is why you might consider selling a put spread rather than an uncovered short put.
Selling the put spread gives you exposure to the same potential opportunity, but with reduced risk. Using the theoretical prices from table 1, you could, for example, sell the 90-85 put spread by selling the 90-strike put for $2 and buying the 85-strike put for $1 ($2 - $1 = $1). Because the options multiplier is 100, for each spread you sell you’d collect $100, less transaction costs. Your potential loss on the trade is then limited to $400, which is the difference between the two strikes, less the $100 credit from selling the spread. And again, remember to include those transaction costs.
Explaining the Math
If the stock drops below $90 at or before expiration (but not below 85), you’ll likely be assigned on your put and get a long position at $90, just like you planned. But if it falls below $85, both the 90- and 85-strike puts would be exercised, leaving you with no position in the underlying stock, but you would have booked a $400 loss. At that point, you can decide if you want to buy the stock at its new (lower) prevailing price, or perhaps sell another put spread with lower strikes.
And if the stock stays above $90 through expiration? The put spread will expire worthless and you’ll keep the $100 credit, minus transaction costs. At that point, you’re free to re-initiate a spread.
So let's say the stock is at $87 at expiration and you get assigned the 90-strike put. At that point you would be long 100 shares of stock, at an equivalent price of $89 per share, ($90 minus the $1 in premium you got from selling the spread).
A Word on Strike Selection
You can also tailor the option spread to meet your own personal risk guidelines. By widening the spread, say to the 90-80 put spread, you can collect a larger credit in exchange for more risk. By selling the 90-strike put and buying the 80-strike put, your credit would be $1.45 ($2 - $0.55 = $1.45), which is $145 per spread, in exchange for a maximum risk of $8.55, or $855 per spread (the difference between the strikes, $10, minus the credit you received, $1.45, times the multiplier). And don’t forget those transactions costs.
How Does the Put Spread Differ from Using a Limit Order?
One difference between placing a limit order order to buy the shares at $90 versus selling the put spread is that, with the put spread, the stock might trade below the strike price before expiration, but then rally above the strike. In that case, assuming you weren't assigned early while the stock was trading below the strike price, your spread will finish out of the money, you will not have been assigned on the 90-strike put, and thus will not be long the stock at $90. For example, if the stock trades down to $89, and then back up to $100 before expiration, you’d have missed out on that opportunity. The flip side, however, is that if the stock never drops below $90, you’ll still keep the credit from selling the put spread.
Bear in mind that the long option holder can choose to exercise their option at any time prior to expiration, so it is possible to be assigned even if the stock is below the strike for only a short time prior to the expiration date.
Such is the nature of options trading—there’s always a trade-off of risk and reward.