Hi all. For those of you who have my book or have read many of the post, you know that a constant theme is the 20% rule. I want to remind all put sellers that follow my method (safety first- profits later) to remember that, that is only a starting point. If you find a position where you used the 20% rule (your chosen strike is 20% below the current stock price)and the return is around 5%, drop down a strike or two and start the position earning around 3%.
However, i wanted to demonstrate by using an example, why I limit myself to using stocks that have a current price around $50 or higher. This is just a guideline and not written in cement, but it is where I usually start.
Assume you have an account balance 7500. You like xyz stock and it trades at 5. You take away 20% and it that says you could use a strike of 4. This pays .10 Your maintenance would be 4.10 for each option. The profit would look like .10 div by 4.10 = 2.4% With your account bal of 7500 you could do 1800 of these. 1800 x .1 = $180 - 180 div by 7500 = 2.4 again.
But with this example all is well with the world. you followed most of my rules and have a decent return. But if the stock drops just ONE dollar you are in trouble.
Now same scenario, but with a different stock price.
Your account bal is again 7500. You find zzz stock selling at 100 and the 75 strike pays .20/.25 If you use the 75 strike (25% below the stock) you receive .20 Your maintenance would be 7.75. You could do [7500 div by 7.75]
900 of these (1/2 of the above example) but you take in 900 x .2 = 180
10 div by 7500 = 2.4%
The point is, that using a much safer strike and doing less options you made the same amount. Don't fall for the trap of 'Wow I can do a lot more of these.' It is return and safety that are important.
I hope I have not confused you to much with all these numbers. If so ask me for clarification.
Never sacrifice safety while trying for higher returns.
Jerry
22 comments:
Hi Jerry,
I understand the math on the example you provided. However, what i have a tough time understanding is that stocks don't necessarily drop by dollar amounts but more by percentages. That is my assumption with stocks, 20% of a 5 dollar stock as oppose to 20% of a 50 dollar stock is 1 dollar and 10 dollars respectively. Isn't this the way we should view selling put options? The only advantage I see with choosing the higher priced stocks is the savings provided from commissions. You'll get more of a premium from 1 contract of a 50 dollar stock as oppose to a 5 dollar stock. Thoughts?
BTW, love the blog. I follow it everyday.
Hi Mark, I relate my starting point as a percentage, as that will fit with most stocks. Especially true as in the example, starting with a stock over $50. I can't say always leave a $20 gap as cushion. Regarding using higher priced stocks it is solely because of the cushion you can get. Example is with AAPL for Feb options. you can make 3% and have 50-60 points of cushion with a quality stock. As you said, there is some commission saving doing less but I try to not factor in commission all that much as it is part of doing business. I go on cushion and then return %. When actually trying to decide between two close stocks I will figure my return by subtracting .01 from the shown premium. I.e; If it says .25 i figure in I will get around .24. I hope I understood your question, if not let me know.
STEVE, I trade mostly at TD Ameritrade. But with a stock price of 100 and a strike price of 75 and a premium of .25, your margin requirements are 6975. This is standard throughout the brokerage community. Is that what you meant?
I hope that also answered your question.
Jerry
I just finished reading your book and found it very well done. You mentioned "Options as a Stratetgic Investment" in the book. That was the first one on options I read, and it probably set me back months in my quest to learn options. Part way through I thought, "my little brain can't comprehend all this", and set it on the shelf. It wasn't till I read a couple books on selling puts that I finally had an "Aha" moment, "this I can do and fits with my mindset". Looking forward to learning with everyone else.
Jerry,
Thanks and yes you did answer my question. After posting my question I went and reviewed the chapter in your book about margin and there it is...the 10% rule, just like you said. Feeling rather silly, I then deleted my question. My broker, OptionsHouse, calculates the exact same margin figure that you did. Next time, I think I'll review your book and then post my question ;-) Thanks again for a great book and a great blog.
Steve, no problem as we are all learning all the time. Don't hesitate to question me as sometimes I get to writing and when reviewing it find I was a mile off..
BobJ. I know the feeling regarding the book by McMillan. It overwhelms you with info but it is considered the option bible. My one complaint regarding that book is while referencing selling puts he always writes about selling puts out 6 months or so. As you know, to me, time is the biggest enemy of put sellers. He doesn't mention the front month idea. But I also keep it as a reference for different strategies that I am constantly exposed to.
I have been asked to talk to groups about options, I always [so far] politely refuse as that field is so wide I would be bombarded by would be experts on butterfly spread and iron-condor etc etc. I just do puts and a few covered calls here and there. I would probably find it embarrassing when asked in front of interested investors What kind of spread works best if your iron condor is in the money...lol. I would be standing there going, Uhh duhhh. I'm sure you get the point. I simplify and do basic things that work for me. I read some other post on different blogs and I wonder, 'how do they know this stuff?' I do puts, I golf and I fly fish a little. That is complicated enough for me.
ps; I also make money and have a good and happy life. It is that easy.
Good trading all...
ps; Keep the questions coming, except that Iron condor-calendar-diagonal spread question.. I Hate that one...
lol
Jerry
Selling Put Options wrote:
>>> Your account bal is again 7500. You find zzz stock selling at 100 and the 75 strike pays .20/.25 If you use the 75 strike (25% below the stock) you receive .20 Your maintenance would be 7.75. You could do [7500 div by 7.75]
900 of these (1/2 of the above example) but you take in 900 x .2 = 180
10 div by 7500 = 2.4% <<<
Hi,
I'm new to this site. Could you explain how you calculate the maintenance requirement more clearly? (In general and for this example). Thanks.
-
Cyrus,
Hi recommend reading Jerry's $10 kindle e-book.
The most common method for calculating margin requirements especially for DEEP OTM Puts is 10% of the strike price plus the Put premium price.
Examples:
60 PUT with .20 premium: 6 + .20 = 6.20 meaning $620 per contract on $20 premium received.
(Margin ROI = .20/6.20 = 3.2%)
125 PUT with .45 premium: 12.50 + .45 = 12.95 meaning $1295 per contract on $45 premium received.
(Margin ROI = .45/12.95 = 3.5%)
250 PUT with .95 premium: 25.00 + .95 = 25.95 meaning $2595 per contract on $95 premium received.
(Margin ROI = .95/25.95 = 3.7%)
Hope this helps.
Cyrus...
Initial margin requirement:
There are two ways to figure you maintenance needed. You will have to use which ever is the largest. I will use the previous example. The stock is selling at 100
I will use the 75 strike
the premium is .25
1. 20% of underlying security value less out-of-the-money amount, if any. Plus the premium.
-100 x 20%= 20 - 20 - 25 (out of the money amt) already the answer is less than 0 So we can't use this way
2.10% of the strike plus the premium--
strike of 75 so 10% of 75 is 7.5 + the prem of .25 = 7.75 maintenance needed.
I hope that is not confusing. In my beginning with options I also had a hard time getting my brain around this. Soon it becomes second nature.
Jerry
OOp's A reader pointed out a mistake in my math from the first post on this thread.
I was writing about the 5 dollar stock and what the maintenance would be. I want to clear this up as it could cause some confusion...
Again..
the stock was trading at 5 and we wanted to use the 4 strike and it paid .10
Either the 20% rule or the 10% rule
The correct amount of maint. would be to use the 10% rule
4 (the strike)x 10% =.40 +.10 (the prem) = .50 maint.
Your new rate of return using the 4 strike would jump to 20% -- .10 div by .50 = 20%
This would be a red flag for my way of trading. As most of you know I always like to start a position at around 3%. So using that strike give you 20%. A definite RED flag
(good catch John) lol
Beginner here, I was looking at quotes, can someone tell me what "Size:2x3" means?
Last: 67.16 -1.00 -1.47% Bid: 67.16 Ask: 67.18 Size:2x3 Vol:1,618,417
I assume that you are referring to the quantity of the bid compared to he quantity of the asked.
It is usually stated B/A 25 X 26 etc, Or in your case B/A 2 X 3
Jerry
Oh the power of time decay.
TCK down $1.55 today. My buy back premium stayed at 0.095 haha I love it.
Trading At 60.87 - Strike 45 - Premium .22 - 10 contracts
Hi Jerry,
What i meant is that i assume stock prices move in percentages rather then dollar amounts. If a 5 dollar stock and a 50 dollar stock both miss earnings, a 20% decrease would be 1 and 10 dollars. They won't both go down 1 dollar each since 1 dollar dollar decrease for a 50 dollar stock is 2%. Is my thinking incorrect?
February Trade I am considering:
DECK (closed 80.44)
Deckers Outdoor Corporation engages in the design, production, marketing, and brand management of footwear and accessories for outdoor activities and everyday casual lifestyle use.
DECK FEB 60 PUT @ .30 bid
ROI on Margin = 4.8% in 39 days
20+ pts cushion (25% out of money)
Prob of Expiration = 95%
P/E = 23
Analysts bullish with consensus target of 90 (nasdaq.com)
Earnings on Feb 23 (after expiration)
Chart: OK, but just recently dipped from a high of 88 (possibly consolidating before next jump)
Status: Watching closely….if price drops, then may consider lower strike.
Note, I retreated from DECK last week on a Jan trade, so I am a little guarded this go round…
John and Jerry, thanks for your responses. It's clear now.
HI Mark, I guess you could say it doesn't matter, as whatever happens is then converted to a percentage measurement. You could say there is no percentage until after the dollar amount is a done deal?
John, I have used DECK often over the years and a good performer for me. But there is still nearly 6 weeks left in the Feb's. Hang on..lol
Also the big earnings are just starting to come in. With options and I guess with stocks, there is a feeling that if you don't move quickly you miss the boat. But there is always a play with options, so take your time and move when all is right. Just my advice..
Thanks Jerry. Wise advice.
I still have a good bit of available maint. left. Anybody see any interesting front month trades to look at.
ed, see my newest post on the front page
Jerry:
In reading through all of this, I see you calculate percentage return based on the maintenance margin required to hold the position. In the past I have always calculated my returns based on the risk I am taking as opposed to what the broker is requiring as margin since selling a naked put exposes me to the stock potentially dropping to zero, or a black swan that could potentially take it down by considerably more than the 20% cushion. I guess I am wondering how I can justify in my mind using the maintenance requirement as opposed to the actual risk as the denominator in the return percentage equation. Any thoughts or insights would be appreciated
Hi Jerry excellent book . What stocks are u using right now to get the 3-5%returns rightnow. Please
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