When A Put Trade Moves Against You, Remember These 3 Things…
If you’re a longtime reader, you know we’re fans of selling put options. They’re a great way to generate extra income in your account.
Maybe you’ve even tried it yourself. The first few times, things went off without a hitch. You generated quick income and moved on to the next trade. A job well done.
But then, something strange happened… You sold puts on a stock only to find that you now own shares of a stock that has traded lower.
What do you do? That’s what we aim to cover today…
First, a brief recap. The put selling strategy includes selling put options that potentially obligate you to buy a particular stock at a specified price for a limited time period. For taking on this obligation, the option seller receives an upfront payment. This is known as a “premium”.
The simplest scenario for traders selling puts would be for the underlying stock to remain above the strike price of the put option. This would ensure that our obligation to buy the stock at a lower level would never come into play. This allows us to keep the income we received from selling the puts without any other encumbrance.
Of course, life doesn’t always follow the simplest path, and neither does trading. There are times when the underlying stock will decline to the point where your put options are exercised. This means you’re left holding a newly purchased stock position.
As a quick reminder, this is not a “defect” of the put selling strategy. In fact, it can be one of the strongest ways to generate meaningful gains — on top of the material income booked on a month-to-month basis.
3 Things To Keep In Mind
If you find yourself in the position of having your put options assigned, there are three important things to remember:
1. This is why we set aside capital.
Whenever selling puts in your account, know that there is always the possibility that the stock will fall and your puts will be assigned. This means you will need to buy the stock. (But remember, you can always close a position before this happens.) For this reason, you should always set aside enough capital to fill the buy order. It’s just proper risk management and should be non-negotiable for the vast majority of traders.
2. This is why we only sell put options on stocks we want to own.
The put selling technique is primarily for generating income. Since you know there is a chance you may have to buy the underlying stock, you should only sell put options against stocks that you would be comfortable owning at a lower price. This way you don’t mind if the put option is assigned. You were bullish on the stock in the first place, anyway.
3. This is why we set up our trades to buy stocks at a discount.
If your put option is assigned, this means two things. First, the stock has declined to a point where the price is now below the strike price of the put option. And second, you received premium for selling the puts, so your net cost is actually below the strike price. This discount pricing helps in the event of assignment. You’re starting out well ahead of those who bought the stock outright at the same time you sold your put options.
Now that we have established that owning the underlying stock can be a good thing, we need to determine how to handle our new position.
From a very broad standpoint, we basically have three choices. We can either 1) sell the position immediately, 2) hold for a rebound, or 3) hedge the position.
1. Selling the stock outright doesn’t usually make sense unless something has changed between the time you sold the put option and when you actually take possession of the stock. But if you have a change of opinion on the underlying stock, by all means sell it. (For example, maybe there is a fundamental shift in the company’s business or a threat from a new competitor.)
2. The second option is to continue to hold the stock, hoping for a rebound. This approach makes a lot of sense if you originally sold the put option on a stock with solid fundamentals in a stable trading range.
When holding onto a stock that has been assigned, it is important to set a risk point. This is the level where you will bail out of the position if it continues to move against you. You can do this with a hard stop order, a trailing stop, or a mental stop. It’s up to you, but you should make risk management your highest priority.
No analyst can fully account for every possible scenario that might happen to a company. So even if you do your due diligence, there is still a chance that the stock could continue to fall well past the level where you expect traders to step in and support the price. For this reason, always have an exit plan. Remember, you can get back into the stock if it begins trading in a more attractive pattern later.
3. The final option is to hedge the position. This approach is particularly attractive for income-focused accounts. One choice is to sell covered call options against the position. This helps to further lower the cost basis and add more income to an account. Then, once the stock rebounds, you will be able to sell it at a reasonable price and get to keep the premium you received from selling the calls.
Action To Take
There are a lot of advantages to using the put selling strategy. When using this approach, it is very important to have a game plan. This way, you’ll know how you will handle your position ahead of time. This helps you avoid making a rash decision when a position moves against you without fully analyzing all of the options available to you.
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