Since venturing into the options world and posting this part of the series into my monthly portfolio update, I’ve received quite a few emails from readers asking me the strategy I have used for my positions.
Now, before we start, I must do warn that options are a derivative tool which can be complicated and dangerous if you are not careful about it. There are plenty of risk management lessons to learn about options which I might do in a separate article because they are just so important.
Personally, I have undertook quite a few strategies with options play depending on the type and exposure I wanted to get myself involved in.
In this article, I will write one of the most favorite strategies employed by folks on writing a put option.
Writing a Put Option
First, let us be clear on what’s a put option is.
According to Investopedia, a put is an option contract that gives the holder the right, but not the obligation, to sell the underlying asset at a pre-determined price at or before the contract’s expiration.
As a writer of the put option, you would then consent to purchase the underlying stock at the strike price, if the contract finishes in-the-money.
Writing a put option is generally used as a way to generate income for investors as the writer would receive the premium that they lock in regardless of what happens to the price of the stock market. In other words, not only will you receive that premium, but will also front-load your expectation on how much you will need to break-even, make a loss or at what stop-loss price should you set.
This information is all front-loaded for you to make that preparation well in advance.
Pros & Cons
In an options contract, you have two parties that transact simultaneously.
When you write a put option, there will be someone opposite your end who has formulated strategies that will benefit his positions over the long term.
As a writer of the put option, your profits are capped at the premium that you locked in right from the start, regardless where the market might moves. Depending on your risk tolerance, you can be ultra conservative with your strategy and write a put option that you are comfortable with. For instance, you can write an ultra-conservative option today for Amazon (Nasdaq: AMZN) at a strike price of $2,500 expiring next month for a premium of $380 per contract (100 shares).
This is what I usually call as ultra-conservative play and the premium that you have written is almost like a 99.9% win scenario. I mean how often do you expect a company like Amazon to fall by 25% in a period of 1 month. That just doesn’t happen very often.
This is also why writing an option is such a popular marketing gimmicks in many courses because gurus can easily tout their winning % rate to participants as it’s almost always a winning trade.
|Source: Analyst prep|
Unfortunately, and like most things in life, things are often taken for granted.
Writing a put option does has its massive disadvantages in the form of a significant loss (defined by the difference between strike and $0), especially if you didn’t set a stop-loss in your trade (although it’s quite rare that we see stocks going down to zero).
Like the above mentioned example for Amazon, it is indeed very rare to see the company dropping more than 25% in a single month. But in a very rare event, it can still happen and this is the risk which I think can easily wipe out an investor’s one year gain in a single swipe.
For instance, did you know that at the peak of the Covid-19 crisis, even companies like Amazon shed 34% from the peak to the trough in a matter of 3 weeks. What this means for investors is that should you be caught in a situation like this as a writer of the put option, you’d be “forced” to purchase Amazon at your strike price at the expiration date. Since the market value is lower than the strike value you will purchase, you will be immediately holding on to an unrealized loss.
Of course, the alternative to that is to close your positions before the expiry and book yourself a nice hot bath in a nice looking hotel to forget your loss.
With that basics understanding of the pros and cons of writing a put option, now let’s get straight to the actual thought process when I usually write a put option.
Actual Case Study – Citigroup (NYSE: C)
Generally speaking, I tend to be very conservative in my strategy when writing a put option.
My goal isn’t really to generate returns and earn passively from writing a put option. In fact, for most of the time, I’m just using this passively to wait for the big moments in the stock market where I could take up positions in the market.
I also do not try to roll-over my position month after month even though that can yield the most returns due to the time-decay playing to the writer’s advantage.
The main objective here is to not get caught unnecessarily when then market turns southwards and you are left with little or no capital to take advantage of that situation when it happens. The premium is a relatively smaller amount in the larger scheme of things that pays you to wait and be patience. Of course, if the market continues to move upwards over time, then the premium will get larger and more significant over time.
Having said that, the mental has to be trained to understand that the strike must be a good entry and one that you are comfortable taking regardless of the situation (entry can always get better in a bear market scenario, we’re trying to get to the very best entry as we can).
So articulating all this theory with a position that I recently undertook on Citigroup (NYSE: C) last Friday.
Citigroup is a company I have been keeping in my watchlist since the post-recovery play takes dominant in the market. I have not tried to put my foot in so far as I thought some of these run looks over-extended. Since then, I’ve been waiting for a pullback and a safer entry range.
Like most other US banks, Citigroup has been on a correction in the past few days since the Federal Reserve concluded the meeting during the mid-week of its June meeting. If you look at the 10-year Treasury Bonds, it spiked up to 1.57% a day after the meeting is concluded to before reverting back to go lower at 1.47%.
The 2-year Treasury Bonds however spiked up and did not come down.
What this means is that while the market is certain in the short-term rates are going up, the market is somewhat less certain that this will spill over to the long term perspective of the bond market. We just don’t know if we are going to get that recovery over the long term or not.
As a consequence, most banks and economic recovery stocks have dropped in the past few days, giving way to another run for tech plays.
Citigroup, in particular have dropped a consecutive of 13 days in a row since it hits the recent peak of around $80 just earlier this month.
It last closed the day at $67.6.
Sensing this as an opportunity play, I quickly draw a chart and found out that there is a strong support at about $67 which it last hits that support back in April. Further, it also coincides with the peak around Jan which I highlighted in red.
Adding to that, there is also a strong upcoming EMA200 daily support at $66, which also coincides with the EMA50 weekly support at $65. I do expect price to rebound somewhat at this level due to the stock being oversold.
To further add to my thesis, there is also a Dow Jones weekly EMA20 support at $33,175 which is not far from here. There is just so much support at this level being justified.
As I mentioned earlier in my article, I tend to take a more conservative approach when writing a put, just to make sure I further reduced the chance of things going horribly wrong when it does.
So, I looked on to the next level of support and found that there is a next layer of strong support at $61.70 and then also at $57.5. This is between another 10-15% drop from today’s oversold level.
|Citigroup (C) Daily Chart – As of 19 June 2021|
Using all this to come up with my decision, I decided to write a put option at the strike price of $60 (in between the next level of support at $57 and $62) at various expiry date, mainly July, August and October.
This coincides with the conservative approach of trying to diversify my exposure through a staggered ladder that I have created for my various options play in the event the market suddenly moves in one particular direction.
|3Fs writing put options on Citigroup|
Fundamentally, I am expecting Citi to report an earnings of about $7-8/share for FY2022 which will bring its PER to around 7-8x. Its current book value is at $75 so we do get some sort of margin safety there.
My mental tells me that this is a good price for entry even if I do get assigned at the worst case scenario. This is important because as a writer of a put option, you need to be convinced that you are not overpaying for a company even if you get assigned and you’d be happy either way to receive the premium or the stock itself at $60.
I hope this formulation and articulation of thought helps in the question that some readers ask me.
There are obviously a hundred and one strategies to articulate and it is very difficult to say which strategies are the best out there. I would just say that get into the strategy that you are comfortable in and works for you and then stick and do some simple and trial error yourself to try a new one.
In my next series, I’ll talk about some of the other strategies I have on other options strategies and the risk I use to mitigate.
Thanks for reading.
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14 thoughts on “My Thought Process On Writing a Put Option – With Actual Case Study On Citibank (NYSE: C)”
Hi B, thanks for the knowledge sharing.
What platform/tool do you use to write options?
Is there a cost involved? platform fee? transaction fee? etc etc? How is the fee calculated? My guess is that the platform gets a cut either from the options writer or buyer or both.
I used Tiger Brokers to write options but the fee they are charging to the public is not cheap (around $3/contract). I do have some special arrangement with them though.
If you'd like it to be cheaper, you can consider IBKR or TD Amtrade, which only charges less than $1/contract but I still prefer the UI for Tiger better so far.
Not sure if you can do a step-by-step guide using Tiger brokers to show noobs like me how to write an option?
Or is it totally idiot proof?
1 contract means $3 for 100 options … how is the option premium calculated? Is there an algorithm that calculates the premium?
Have heard about options writing many years ago and would like to give it a try (without burning myself) … maybe start dipping my toes into the water slowly and gently. thanks
It's not rocket science but its definitely not idiot proof either. There is still a lot of risks that come with considering many things. I suggest reading up first on how the premiums are being calculated and what factors are affecting it for example, IV, Theta, etc. From there, I think is easier if you give it a try and write just 1 contract first from a safe investment (think mega cap).
Hi Brian, Fabian here.
Tigers fees seem expensive at first glance but that $3 is like a minimum order fee. it's actually 95 cents a contract. all USD
Hmm, it is still showing as about USD3 / contract in my order detail, is yours after deducting the free comm and all that's stuff that Tiger is giving to its users?
Nice work, have been selling puts on AMD and was happily assigned at 78 few month back.
$78 is a good price for AMD, it sits nicely in the EMA50 weekly support. I have a couple of open positions put too for AMD at that price.
Nice article ! Not sure if I missed out something but could I check if Tiger would be able to locate the cover automatically like IBKR by buying the shares at the strike price or would the platform choose to close the option contract at market order instead ?
Tiger would automatically assign for you by getting you the shares at the strike price upon expiry of the options.
Thanks for the nice article. I agrees that options work wonder for long term investors as one of the tool to acquire shares at cheaper price. I am wondering why Singapore does not have options market and not so common in Hong Kong market.
relatively new to options as well (just wrote my second put option), but I'll like to ask what is the rationale of writing multiple options across different expiry dates at same strike price? Should the underlying stock price really drops below $60, wouldn't you possibly be forced to buy multiple lots at the same time? Max exposure almost $200k.. is it just simply that it is an exposure you are comfortable with?
Hi Brian! 1 contract is 100 shares, why is yours showing 10, 20 , 3 lots respectively??
the wall of debt is kicked down the road to sep 2021
market seems to be forming the right shoulder, correction or crisis?
100% cash position ready for the next big one
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