Long Stock vs. Short Put: Trading Lessons From An Engineer | tradeTALK Series
Apr 15, 2021
Getting started in trading is never easy, however, regardless of your background you can learn to become an efficient and effective trader. The short put trade might serve as a great starting point. In this TradeTALK, Jermal Chandler explains how he got into self-directed investing, the basics of long stocks and short puts, and how you can decide which strategy is best for your goals.
When I was a newbie in the trading industry, I wanted to hear the sage advice of those who had been trading longer than myself. You see, I had limited knowledge because I left behind a life of laboratory work and scientific papers to pursue a career in trading.
Why? Well it was my understanding that the generation before me was seemingly set up nicely for retirement. They would receive social security and payouts from company-sponsored pensions. So my desire to become a trader stemmed, in part, from the fact that I wanted to learn how to be a self-directed investor since retirement money seemed uncertain.
I became a trading assistant at a proprietary trading firm and was fortunate enough to learn from some of the best traders in the industry. The learning program consisted of options theory courses, real-time portfolio trading and discussions with experienced traders. These mentors can inspire confidence and also inject their own fears into a young trader’s mind.
One of the prevailing schools of thought from the senior traders at the time was “under no circumstances should you ever sell a put naked”.
Where did this come from? Why such fear-mongering over a simple trade? Well, in some respects, it goes back to the stock market crash of 1987. The harrowing experience of a steep decline in U.S. stock prices over the course of a few days in October 1987 clearly scared the bejesus out of the men and women who lived through it.
I must say that the fears were not unwarranted. Once I sat on a trading desk and managed a volatility portfolio during the 2008 Global Financial Crisis, I immediately understood all of their concerns. When you see the market capitalization of once-venerable companies like the former Bear Stearns vanquish right before your eyes, trust me, you get it.
After years of trading professionally, I eventually found myself teaching the principles of option trading to those who wanted to become more active with their own investments. To my surprise, while often discussing the risks and rewards associated with option strategies, I began to re-formulate my thinking around several strategies. In particular, I realized that my old friend, the short put trade, was not such a terrible idea in certain situations.
The strategy is a prime candidate to test the Tastytrade tenets:
Markets are random
Law of large numbers
Managing winning trades
Since it’s impossible to know what the market it’s going to do it’s best to trade small and often. Data shows that selling premium can have a higher probability of profit than buying premium over time. However, it is perhaps most important to manage winning trades before they get away from you.
Let’s compare the short put trade to getting long stock.
The majority of investors look to purchase stock when they are bullish on a company because it’s fairly straightforward. You can buy shares at the current price with the hope that they appreciate in value.
The benefits of buying stock are unlimited upside exposure and the ability to collect dividends. As far as drawbacks, the only way to make money on a long stock trade is for shares to appreciate in price. Additionally, the cost to purchase 100 shares of stock in many equities can tie up lots of investment dollars thus making it capital intensive.
For example, let’s say we want to buy shares of Advanced Micro Devices (AMD). In order to purchase 100 shares of stock at $85.72, we must put up $8,572 for that transaction. While this trade has unlimited upside profit potential it is very capital intensive. Additionally, AMD does not distribute a dividend.
Buying AMD stock is a perfectly suitable strategy for being bullish since the risk/reward is rather simple. Although, when you analyze it from a probability standpoint, you have roughly a 50% chance of making a profit on long stock.
You can only win in one direction, which is stock moving upwards.
Another way to express a bullish sentiment is to sell a put option with the hope that the stock rises. At expiration if the stock is above the put strike, then the option expires worthless and the seller gets to keep the premium.
There are several benefits to the short put trade. Depending on the chosen strike price, you could potentially purchase stock at a lower price should you get assigned at expiration. It is a long theta trade and thus will benefit from the rate of decay of an option. Finally, this trade has the ability to be successful if the stock goes up, remains flat or trades down slightly. A multiple win scenario is a nice added feature.
However, the short put trade does have two drawbacks. The maximum profit potential is limited to the premium received at the outset of the trade. On top of that, it is not possible to collect a dividend by selling a put.
Let’s say we decide to sell one contact of the AMD 82.5-strike put for $5 in premium. Our expiration breakeven, which is the put strike minus the premium, equates to stock trading $77.50. Below that the trade loses money.
We could potentially be obligated to purchase 100 shares if AMD is trading below our strike price at expiration but luckily we already identified $82.50 as a place where we are comfortable buying shares. Not to mention that by collecting $500 in premium we would receive a discount of sorts to purchase stock should we be assigned.
If the stock is trading above the 82.5-strike at expiration then the option expires worthless and we keep the premium. We can attempt the same trade again in another expiration.
This strategy can profit if AMD is trading $85 at expiration which is above the 82.5-strike. It can profit if AMD closes at $82.50 at expiration, and it can profit if AMD is below $85 but above $82.50. There are multiple ways to win on this trade.
On the flipside, we do have to be mindful of a maximum loss scenario. Once AMD is trading below our breakeven of $77.50 we begin to lose money on our short put trade. As the stock goes down further, our delta becomes more positive and our profit and loss profile begins to mirror that of being long stock. We would lose the most money if AMD trades down to zero.
Long stock has unlimited upside profit potential at the expense of a lower probability of profit. Selling puts increases the probability of profit, improves cost basis but has limited profitability. Both are suitable strategies, but the right strategy depends on the trader’s assumption.
If you are bullish on a stock then you might be willing to sacrifice probabilities for a higher potential payout if your direction assumption is correct. If you want to collect premium and are content with the potential obligation to purchase stock at a lower price, then you might be comfortable selling puts.
Find out for yourself and see which works best for you. We have plenty of research regarding both strategies so head to tastytrade.com for more information!
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