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Option Strategies (Archived)

Terminology

Limit Order

An order to buy shares at a price that is less than the best Ask price or an order to sell shares at a price that is more than the best Bid price. A Limit Order will only be filled if the stock price reaches the limit order price.

Market Order

A Market Order is a trade order to either buy stock at the best Ask price or to sell stock at the best Bid price. The market Order will be filled almost immediately.

Short Selling Options

Short selling an option occurs when an option is sold that the trader or investor does not own.

Buying Stock with Short Options

Investors can acquire stock with short put options - and collect the option premium

picture short options

Investors who do not want to pay the current market price for a stock will either wait for the stock price to drop to their preferred level or they will place a Limit buy order. For these investors there is an alternative method of acquiring stock and that is to short sell a Put option over the stock.

When an investor short sells a Put option they receive the option premium - which is the price the option buyer paid. Also the short seller has the obligation to buy the stock from the Put option holder if the Put option holder decides to exercise their right. As a general rule, only Put options that are in-the-money are ever exercised and they are usually exercised on the options expiry date.

For the most part buying stock with a limit buy order is the same as acquiring stock with a short put option. Both methods require the stock price to fall down to a predetermined level.

One difference between the two methods is that the investor will receive the stock as soon as the stock price falls down to the limit price, whereas with the put option the stock price will typically need to be at or below the strike price at expiry (this is because Put options are rarely exercised before expiry even if the stock price is below the strike price) Therefore it is more difficult to acquire stock with a Put option compared to using a Limit buy order.

Another consideration is that the investor receives the premium for short selling the put option - regardless of whether the option is exercised or not. Also the option contracts are usually for 100 shares - which may not suit the investor.

In order to utilize the Put option strategy the stock must have Put options available. Not all stocks have options and if they do the strike prices may not be suitable. Some stocks have a wide range of options. An example of short selling Put options to acquire stock is shown below with Microsoft Corp.

Chart 1. Short sell Put options

options Chart MSFT

Chart 1. above shows that Microsoft Corp. closed at $36.86 on 30-Jan-2014.

Microsoft Corp. has a wide range of Put options available. Before the market close an investor had a choice of strikes they could have short sold with an expiry of 21-Feb-2014 (about three weeks till expiry).

Put options

  • Strike $37.00 with premium $0.72
  • Strike $36.50 with premium $0.50
  • Strike $36.00 with premium $0.34
  • Strike $35.50 with premium $0.23
  • Strike $35.00 with premium $0.16
  • Strike $34.50 with premium $0.11
  • Strike $31.00 with premium $0.02

Options that are at-the-money have the highest premium (time value that the option holder pays for). The premium received by the short seller drops as the Put option strike price gets further out-the-money. Also the chances of the Put option holder exercising their option decreases as the Put option strike price gets further out-the-money.

The highest premium is with the $37.00 strike but this does include around $0.14 of intrinsic value as this option is slightly in-the-money. The $36.50 strike is the first Put option that is out-the-money.

Referring to Chart 1. if the investor choose the $34.50 strike - this is basically the price level where traders typically place their stops.

If the investor is looking for a more significant discount they might be considering the support that exists at the $31.00 strike level. However the premium at this strike is only $0.02.

The investor needs to decide what price they wish to buy the stock. With a Limit buy order this is as simple as selecting the limit price. With short selling a Put option, the investor is restricted to the strikes available. The general rule is that the further out-the-money the strike is then the lower the chance of acquiring the stock.

Chart 2. below shows how Microsoft Corp. traded for the next three weeks until the options expired on 21-Feb-2014.

Chart 2. Put options at expiry

options Chart MSFT

As can be seen from Chart 2. above, Microsoft Corp. closed at $37.98 which is higher than all the strikes that were listed above. While Microsoft's stock price did drop below $36.00 it then rallied up to around $38. Therefore none of the Put options would have been exercised.

The short sell Put option strategy works well for the investor that wants to acquire the stock as they also collect the premium (and will probably collect this several times before they acquire the stock). Basically the further out-the-money the option is then the investor will receive a lower premium but will receive the premium more often until they are exercised.

A problem arises when the investor only wants to receive the premium but not the stock. Even the further out-the-money put options (like the $31.00 strike) will get exercised sooner or later. This means the investor has to pay the Put option holder $31.00 for the stock. This is a problem for the investor who does not want the stock as they received and paid for it anyway.

In general acquiring stock with a short put option is a viable alternative to placing a Limit buy order, but the investor needs to keep in mind both of these tactics does not ensure that they will receive the stock. If the stock rallies then a Market order is the only way to ensure that the investor will receive the stock.

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