Introduction to Options – Selling Puts

In previous articles in this Rich Dad Education series, three fundamental building blocks to option strategies were discussed: the buying of calls, the buying of puts, and the selling of calls. These building blocks are taught and reinforced in Rich Dad Education elite trainings. Understanding the mechanics of these building blocks and the appropriate use of each one is essential for traders wanting to use options. This article will cover the fourth and final option building block, the selling of puts.

Difference Between Buying and Selling Puts

When traders buy puts, they are anticipating a bearish move on the stock. The put buyer then has the right to sell that stock at the agreed upon price on or before expiration date. The hope for the put buyer is that the stock will fall in price so the premium they paid for their option will increase in value.

Traders should always be aware that there are two sides to every option. While put buyers have rights to sell the stock, the sellers of put options have the obligation to buy the stock at the same agreed upon price at or before the agreed upon expiration date. For example:

• Put Buyer: Pays $2.00 premium for $50 Put for March expiration
• Put Seller: Collects $1.90 credit for $50 Put for March expiration
• Market Maker: Collects $.10 for facilitating the transaction

In this scenario, the put buyer and put seller have agreed upon the $50 strike price in March. At any time before expiration, the put buyer may exercise the right to sell 100 shares of the stock at $50 per share. For this right, the buyer pays $2.00 per option contract. If assigned, the put seller has the obligation to deliver at $50 per share. For this obligation, the put seller receives a credit of $1.90 to their account per option contract. The market maker keeps the bid/ask spread of $.10.  Three scenarios can occur at this point at expiration:

1. The stock can stay above $50. In this case, the put seller is still obligated to buy the stock from the put buyer. Of course, the put buyer is not going to want to sell the stock for $50 when the market price is higher. The sold put expires worthless and the option seller makes his maximum profit of $1.90 minus commission.
2. The price of the stock at expiration will be somewhere between $49.99 and $48.10. In our example, the put seller received a $1.90 credit for selling the put option. If the stock is at $49 at expiration, the put seller is obligated to buy it at $50, but the total credit will still make the trade profitable. In this example, the put seller would net 0.90 per share. This is usually accomplished when the seller buys back the put option at the lower price. If not bought to cover, you will be assigned the stock.
3. The price of the stock at expiration will be below the put seller’s break-even point, in this case $48.10. The put seller is obligated to buy the stock at $50 no matter how low the current price of the stock is or the seller must buy back the option at a price that is higher for a loss. It does not matter whether the stock is $46, $40, or even $0.01. The put seller still has to purchase those shares at $50.

Selling Put Options – Review

1. You can sell a put: Some traders sell puts on stocks that they believe will go up in price or at a minimum stay at a price above the strike price they sold.
2. Selling a put is a credit trade: you receive a credit when you sell the put.
3. You have unlimited risk with selling puts.
4. You have limited reward from selling puts. The most you can make is your premium.

When Should You Sell Puts?

It is important to understand the mechanics of selling puts and the obligations associated with them. Gaining this level of comprehension will help you make sense of the world of options and will serve as a building block to learning option strategies that can be very helpful. While there are some advanced techniques to enter long-term investments where selling puts can be very useful, generally one should avoid the selling of puts. Selling puts carries with it tremendous risk due to the obligations associated with them. There are numerous other option strategies that can help you mitigate risk while still reap a tremendous return on your investment.

Introduction to Options – Selling Calls

The previous article in this Rich Dad Education introduction to options series discussed the risks associated with selling calls. Rich Dad Education elite trainings, mentoring programs, and other educational offerings can help students take advantage of selling options without taking on the enormous risk of simply selling call or put options. For this reason, credit spreads and covered calls are extremely popular topics covered in Rich Dad Education trainings.

If you choose to take advantage of the potential that credit spreads and covered calls can offer you, it is important to take the time to understand the fundamentals of selling options. The selling of calls is often referred to as naked calls because the call is unprotected from unlimited risk. While it’s possible you may never sell a naked call, understanding how they work will be very beneficial.

Naked Call Example

When traders buy calls, they are anticipating a bullish move on the stock. The call buyer then has the right to buy that stock at the agreed upon price on or before the specified expiration date. The hope for the call buyer is that the stock will rise in price so their option will also increase in value. If this occurs, the option buyer has two choices:

1. They can exercise the option, in which case they will buy the shares of the underlying stock and then sell it for a profit in the market, or
2. They can sell the option back at a profit

There are always two sides to every option. While buyers have rights to buy the stock, the sellers of call options have the obligation to sell the stock at the same agreed upon price at the chosen expiration date. For example:

• The stock is trading at $50 in the market
• Call Buyer: Pays $2.00 premium for $50 Call for March expiration
• Call Seller: Collects $1.90 credit for $50 Call for March expiration
• Market Maker: Collects $.10 for facilitating the transaction

In this scenario, the call buyer and call seller have agreed upon the $50 strike price in March. At any time before expiration, the buyer may exercise the right to buy 100 shares of the stock at $50 per share. For this right, the buyer pays $2.00 per option contract. If assigned, the call writer has the obligation to deliver 100 shares per option contract to the buyer at $50 per share. For this obligation, the call seller receives a credit of $1.90 to their account per options contract. The market maker keeps the bid/ask spread of $.10. Three scenarios can occur at expiration:

1. The stock stays at or below $50. In this case, the call seller is still obligated to sell the stock to the call buyer. Of course, the call buyer is not going to want to go buy the stock for $50 when it is selling for less. The sold call expires worthless and the call option seller makes his maximum profit of $1.90.
2. The price of the stock is between $50.01 and $51.90 on the last trading day. Remember that the call seller received a $1.90 credit for selling the call option. If the stock is at $51 at expiration, the call seller is obligated to sell it at $50, but the total credit will still make the trade profitable. In this example, the call seller would net $.90 per share. This is usually accomplished when the seller buys back the call option at the lower price.
3. The price of the stock is $51.90 or higher. The call seller will experience a loss. Typically the call seller will buy back the call option at a price higher than the original sale. The seller is obligated to sell the stock at $50 regardless of the market price of the stock. It does not matter whether the stock is $52, $60, or even $100. If assigned, the call seller must purchase 100 contracts at the market price and deliver them to the buyer at $50. This is why selling call options is sometimes referred to as naked calls. You are naked, having no protection if the stock takes off.

These examples demonstrate the rights that buyers have and the obligations that sellers have.  Call buyers and sellers will always have different desires on where they want the price of the stock to go. The buyer of the call option will always want the stock to rise as they have unlimited upside with their option. The call seller will always want the stock to stay below the strike price they sold so they can keep their entire credit.

Introduction to Options – Selling Calls

The buying of calls and puts are two fundamental concepts that are taught to Rich Dad Education students. These and other option strategies in conjunction with knowledge of technical analysis are passed along to students through elite trainings and other Rich Dad Education offerings.  Once a student has acquired the proper training, they have put themselves in a position to take advantage of the numerous opportunities the market presents.

Rich Dad Education trainers and mentors often teach their students the basics of buying calls and puts before other options strategies. This is logical as these two option instruments can be used independently and also serve as the foundation of numerous option strategies. After a student learns about buying calls and puts, the next sequential step is to learn the final two option building blocks — the selling of calls and puts. These final two building blocks usually require a note of caution due to the additional risk associated with them if they are used as stand-alone strategies.

For example, when a trader buys a call, they know what their risk in the trade is. The maximum risk is the premium they paid for the option contract. If the trader buys one call option at $2, then their maximum risk is:

$2 x 100 shares = $200 plus whatever commissions apply

If they buy a $50 call options contract for $2, then even if the stock goes to zero the most they can lose is $200. This is due to the fact that they have the right, but not the obligation, to buy the stock at $50. If it goes to $10, then they simply take their loss on the trade, but they know ahead of time what that maximum loss may be.  Knowing the risk that one has in selling options is not so straightforward.

Rights and Obligations

While learning about options you must always keep referring to the different rights and obligations that option traders have. A new trader will rarely have this memorized on first glance, but referring to it occasionally will help the concepts sink in.

Option Buyer (option holder): When purchasing an option contract the buyer has the right, but not the obligation to buy (for calls) or sell (for puts) a security or other financial asset at an agreed upon price (the strike price) during a certain period of time or on a specific date (exercise date).

Option Seller (option writer): When selling an option contract the seller has the obligation to sell (for calls) or buy (for puts) the shares to (or from) the buyer of the option at the specified price upon the buyer’s request.

When a trader buys a call option, they have the right to buy the stock at the agreed upon price. This right limits the risk the trader has. However, when an individual sells a call option, they inherit certain obligations.  These obligations center on the price that the option seller must sell at. The nature of these obligations bring with them a higher level of risk because the amount a trader can lose is not fixed at the time the option contract is sold.

Maximum Risk on Selling Calls

The maximum risk that a seller of calls has is theoretically unlimited. The exact formula is:

Difference between stock price and strike price plus credit

You will notice the term “credit” is used here. When you buy a call option, your account is debited the amount of the premium. However, when a trader sells a call, the amount of the premium is credited to their account. If they sell a $2 call option, their account is credited $200 ($2 x 100 shares).  When a trader sells a call option, they often are betting that the stock will stay below the price they sold at. If they sell a $50 call, then they are obligated to sell 100 shares of the stock for $50 and must fulfill this obligation if asked to do so. As long as the stock stays below $50, the trader gets to keep the full credit and makes their maximum profit.

However, if the stock goes above $50, then the trader must still sell the stock for $50. If it goes to $55, they are obligated to sell at $50. If it goes to $65, they are still obligated to sell at $50. If it goes to $100, they have the same obligation. This can create situations where new traders can sustain huge losses due to the unprotected nature of the sold call.

Receiving a credit in one’s account often gets traders excited. Who doesn’t like money put into their accounts!? Rich Dad Education elite trainings and other educational offerings help students take advantage of this excitement by teaching them about credit spreads. Credit spreads can help take advantage of this credit while limiting a trader’s exposure to risk.

Introduction to Options – Put Options

Rich Dad Education trainers take their lifelong trading experience and pass it along to students through various educational offerings. This experience helps prepare students to approach the market in a logical and consistent manner. It also helps students identify and take advantage of a variety of market conditions. Identifying bearish conditions and knowing when to enter the market can be a highly profitable endeavor.

Put Options

The buying of put options is a simple and straightforward approach in which a new trader can take advantage of bearish trade setups. Here is a basic overview of put options:

1. You can buy a put: puts are bought on stocks that traders believe will go down in price.
2. Your entry into a trade using puts should be determined by your technical and charting knowledge of the stock.
3. Buying puts does not benefit from time decay.
4. You have theoretically an unlimited reward from buying puts to the point where the stock goes to zero.

Buying Put Trade Setups

 Rich Dad Education students are trained to identify bearish trade setups. They are never forced to rely on guessing or their gut. Traders who simply buy put options because they are sure the market is going down based on their feelings exhibit extreme novice behavior and can be severely punished by the market.

Here are some technical criteria to look for when attempting to identify potential bearish trades.

Strong Areas of Resistance

When you identify strong areas of resistance, you gain solid knowledge of how the stock may potentially behave. Strong areas of resistance often keep the price from going above that price area and can give you valuable knowledge on when you should enter a bearish trade. Traders often attempt to identify a stock in a bearish trend and then enter into the trade via buying a put when the stock hits one of these areas of resistance and then starts to head down again.

Bearish Trends

When buying puts, it is wise to be trading in the direction of the trend. Strong bearish trends enhance the probability of a winning trade. Traders that attempt to buy puts when a stock is going up can have occasional success by identifying short-term halts in the trend; however, this is similar to fish swimming upstream. Traders can simplify their lives and trading by going with the trend as this tends to increase the probability of success.

Overall Market Trend

If the broad markets are in a downtrend then this helps the chances that the stock might get pulled along with the trend. The same logic of swimming upstream applies. Don’t try and be the smartest trader in the world by identifying narrow windows where you can trade against the trend. Simply go with the trend and enjoy the highly profitable results.

Breakouts of Strong Areas of Support

It is a well-known fact in the trading world that stocks fall faster than they rise. Identifying when these fast falling periods may occur can be extremely profitable. When the price of a stock falls through a price area that had previously demonstrated strong support, the results can often be quite dramatic. It is important to learn to identify these areas of support. Once these price areas fail, you need to develop trading rules that help determine when you should enter the trade. The buying of a put can be the trading instrument you use to profit in these scenarios.

These are just a few of the basic, yet fundamental things you should look for in determining whether it is appropriate or not to enter a bearish trade. There are many bearish strategies that can be used to profit from these trade setups and the buying of a put is one of them. The next article in this Rich Dad Education Options Series will cover another of the four option building blocks, the selling of calls.

Introduction to Options – The Put Option

Rich Dad Education students are taught that they can profit from any market environment. Rich Dad Education elite trainings and mentoring offerings teach students strategies that can be applied to take advantage of bullish, bearish, and even stagnant markets. The ability to take advantage of various market environments gives knowledgeable traders a tremendous advantage over the common investor who traditionally simply buys a stock and holds it. The last article in this Rich Dad Education series on options discussed the buying of a call option, which can be used to take advantage of a bullish market.  Buying put options is a potential approach to take advantage of the bearish market environments that you will encounter.

Put Option

Those new to trading usually grasp the concept of call options with relative ease. For some reason, it usually takes those new to trading a little longer to grasp the concept of puts. If you find that this is the case with you, then think of calls and puts in the following simplified terms:

• Buying calls: You buy calls when you think the market is going up
• Buying puts: You buy puts when you think the market is going down

At the most basic level this describes the buying of calls and puts. They are simply an instrument you can use when you think you have an idea of where the market is heading. You can buy a call option when the market is going to go up or buy a put option when the market is going to go down. Naturally, there is a tad more that goes into your evaluation of the market’s direction, but that is the basic premise of buying puts.

Even if you do not ever plan on buying a put, it is important to understand how they work as they serve as one of the four building blocks of numerous option strategies.

Put Option Basics

• When Used: When traders expect the underlying stock to move down in price.
• Put Buyer’s Rights: Gives the contract buyer the option of selling the stock in the future at a set price before the contract expires.
• Maximum Risk: Price of option premium. You can lose 100% of your investment.
• Maximum Reward: Unlimited to zero.

Put Option Example

Where call buyers have the right to buy a stock at a set price, put buyers have the right to sell a stock at a set price. For example, a call buyer who bought a $50 call option has the right to buy that stock at $50 at any time before expiration. For the put buyer that bought the same $50 put, they would have the right to SELL that stock at $50 any time before expiration. Because the put buyer has the right to sell the stock at $50, they naturally have reason to believe that the stock will go down in price before expiration. In many cases, the put buyer owns the stock and wants to hedge a loss through the purchase of puts.

Here is an example of buying puts. Let’s assume you are extremely bearish on company XYZ. The company has been trending downward for months and has hit a level of support at the $50 price level multiple times and a breakdown pattern appears to be occurring. Your analysis of the chart shows that once the stock breaks the support of this $50 barrier, there could be significant movement downward.

You decide to buy one put option to capture this potential price movement. Remember that each option contract controls 100 shares of the underlying security. In purchasing this put option you now have the option and right to sell 100 shares of stock at the price agreed upon before the contract expires.

You are not forced to sell the stock in the future at $50, you simply have the right to do so if you so desire. If the stock continues to fall past the $50 area of support, then the put you purchased becomes more valuable. Conversely, if the stock rises in value, then you have no obligation to sell the stock at lower prices. Let’s examine some scenarios that may occur when your put option expires.

Stock closes at $50 or higher: In this scenario the trade did not go as expected. If you still hold your put option at expiration, then it will not have any value and you will lose the premium you paid for the option.

Stock closes at $48: In this scenario you have the right to sell the stock at $50 even though the price of the stock is $48. Your profit would be $2 x 100 shares minus the premium you paid for the put option.

Stock closes at $45: You make an even bigger profit as you still have the right to sell the stock at $50. Your profit would be $5 x 100 shares minus the premium you paid for the put option.

The buying of put options can be a profitable means to take advantage of bearish market conditions. While it is far from the only instrument taught in Rich Dad Education educational offerings, it is one of the first ones used by many new traders. The next Rich Dad Education introduction to options article will focus on the technical setups that can make the buying of put options highly profitable.