Put It This Way – Profiting From Put Options

by Russ Allen

Recently I’ve written about hedging strategies that use options. One of the strategies I’ve described was buying put options as insurance. Another was selling covered call options against the stock position, to reduce its cost and therefore its risk. Yet another was to combine those two strategies, in what is known as a collar.

All of these methods assume that we want to continue to own the stock. Today we’ll take a different tack, which involves selling the stock to take profits now, and making a plan to re-purchase it at a discount later.

If we think the stock has had about as much of a run as it’s going to get for now, we can simply sell it and bank the profits. A bird in the hand has been kept from flying away, to stretch a metaphor.

But we can set a trap for more birds. If we can identify a lower price at which we would like to buy back in to the stock, we can use options as a way to be paid for waiting for the stock to reach it.

Here is a chart of TLT, the exchange-traded fund that owns long-term U.S. Treasury bonds.

Figure 1 – TLT weekly chart 

TLT has had a very good run over the last year, rising over 14% while also paying dividends of around 3%. Not bad for something as prosaic as government bonds. But let’s suppose we think it is likely to fall from here, back toward its long-term trend, and to pull back to around $114-115. (This is not a recommendation. We’re just supposin’ here).

If that is our opinion, we could sell TLT now and bank our gain. We could then put in an order to buy it back at a limit price of $115. If it were to drop that low, our order would be filled and we’d be back in the game. If TLT holds at its long-term trend and begins to rise again, we’ll be aboard for another up cycle.

We could do a little better than just hoping to buy TLT at $115 though. We could get paid for being willing to buy it.

This would be accomplished by selling cash-secured put options on TLT. Looking at the available put options, we can see that there is a bid of $1.17 per share for the January put options at the 116 strike price. These expire on January 16, 58 days from now. We can sell these puts (it’s also called “writing” the puts, because we are creating them and then selling them to someone else), and receive $1.17 per share, or $117 for a hundred shares.