My Favorite Tool in the Trader’s Swiss Army Knife
There’s no better way to inaugurate my pages in TOM than with a discussion of my favorite trading tool: put selling.
When I was in the military, I always had a Leatherman clipped to my belt. If you’re not familiar with a Leatherman, it’s like a pocket knife with a pair of pliers and additional tools stored in the handles. Basically, it is a save-the-day kind of tool.It wasn’t a fashion statement. It was a necessity. Within days of enlisting, I learned about the importance of a multitool, and I used my Leatherman multiple times a day in the Iraqi desert and other places I was deployed. In my post-military life, I do make some concessions to fashion. Now I keep my Leatherman in the truck and carry a Swiss Army knife in my purse. That knife still raises eyebrows among the other moms, but the full Leatherman would lead to social exile, even out here in the wild west of Wyoming. So I don’t make as much use of it these days.
Unless this is your first-ever issue of True Options Masters, it’s safe to assume you already know a thing or two about trading options.So, for now, I’ll skip telling you about how I use options to benefit from price moves. (Though, there’s plenty of that in store.) Instead, I’ll focus on another use of the Swiss Army knife of trading… Buying index funds on the cheap, and getting paid for the privilege. Let me explain…
Stop Trying to Time the Dip
Many traders hold index funds. Often, they also hold some cash and wait for a dip to buy more of the index fund.In this long bull market, I’ve met people who have held cash for years, waiting for the ideal opportunity to buy. But when the dip comes, they wait because they think there could be a bigger dip. Eventually, prices recover, and they never buy. But by using options, you can avoid this. Let’s say you have $50,000 in cash right now and want to buy a dip. We’ll use 5% as the definition of a “dip.” Let’s say the SPDR S&P 500 ETF Trust (SPY) is trading at about $469. After a 5% dip, the price would be just under $446. But, if the price falls that far, you might decide there is more downside. Instead of buying, you wait for a bigger dip. If prices don’t fall further, you wind up not making a move and miss the dip. To ensure you act if and when a dip occurs, you can sell a put option. This ensures you’ll buy the dip when it comes. And even better, you’ll get paid to do so. In this case, you can sell a January 21, 2022 $446 put for about $6. That’s a contract to buy 100 shares of SPY for $446 if the ETF is trading below $446 on January 21. When you open the trade, you receive $600 per contract. Then, two things can happen. If SPY is below $446 when the put expires, you will need to buy the ETF. That will cost $44,600. That puts your cash to work at the price you wanted to pay for SPY in the first place. And since you already received $600 to sell the put, you can put that toward buying SPY. If SPY continues higher and the option expires, you simply keep the $600. In that case, you earned 1.2% on your $50,000 in cash over two months. That’s more than your broker will pay in a year. And if SPY continues moving higher, you can repeat this trade every two months, or even every week, to generate income.
Put Selling Is Not Risk-Free
Now, put selling is a great options strategy, and it’s one I practice regularly. But it’s important to know that it has its risks.
Selling put options requires significant funds in your account, to ensure you’re able to exercise the option and buy the 100 shares per contract if you’re obligated to. This is important to consider because you’ll be allowed to open the trade with a lot less capital.In a typical trade, you will need about 20% of the required capital to open a position. If you are forced to buy, you will need at least 50% of the capital in a margin account. In a cash account, you will need 100%. In the SPY trade, you will need about $8,920 to open the position. If exercised, you need at least $22,300 in a margin account or $44,600 in a cash account. That’s another thing… By selling a put option, you may be obligated to buy the shares if the buyer chooses to exercise the contract. Normally, as an option buyer, you have the choice. Not as a seller. Obviously if the price of the stock or ETF is below the strike price of the option at expiration, you will be exercised. But you can be exercised early and you will need the cash to buy the shares if that happens. Early exercise is rare, but you must be prepared for that. Option selling, like all short selling, also means your downside can be extreme in volatile situations. If SPY fell to $430 in the above example, you can quickly go into the red. When that option is exercised, you will immediately have a position with a large loss. There are ways to manage this risk, and I’ll address them in the future. So as long as you’re aware of these risks, don’t overleverage your trades, and keep enough funds to cover the purchases, you should be prepared to sell put options. But the wonderful thing about options is this is just one of many ways to trade them. Just one tool in the Swiss Army knife. I’ll introduce more of these tools in the coming weeks. Regards, Amber Hestla Senior Analyst, True Options Masters
Chart of the Day:I Spy With My Little Eye
Do you see what I see on the 4-hour Ether (ETH) chart today?I spy an inverse head-and-shoulders setup… A bullish cross on the MACD… An RSI not even CLOSE to overbought… And new local highs on the ETH/BTC ratio pair. What does all this spell? An imminent ETH rally. I’m unfortunately on the road as you’re reading this. So I’m writing this Chart of the Day a bit earlier than I normally would, early Tuesday afternoon. But I’m banking on this being a hugely bullish setup over the next few weeks, and the start of the journey to new highs in ETH and most altcoins. By the time you read this, we’ll know if I’m right. Even if ETH has made a big run by Wednesday morning, this is one to own for the final leg of this bull market. We’re more than likely looking at a 2x here, at minimum. Position appropriately! Regards, Mike Merson Managing Editor, True Options Masters