So you may have tried selling puts to generate extra income in your account, only to find that you now own shares of a stock that has traded lower.
The put selling strategy includes selling put options that potentially obligate you to buy a particular stock at a specified price for a limited time period. For taking on this obligation, the option seller receives payment -- or a "premium" -- which represents income in the investment account.
Of course, life doesn't always follow the simplest path, and neither does trading. There are times when the underlying stock will decline to the point where our put options are exercised and we are left holding a newly purchased stock position.
As a quick reminder, this is not a "defect" of the put selling strategy. In fact, it can be one of the strongest ways for us to generate meaningful gains in our account -- on top of the material income booked on a month-to-month basis.
If you find yourself in the position of having your put options assigned, there are three important things to remember:
1. This is why we set aside capital.
Whenever we are selling puts in our account, we know that there is a possibility that it will be assigned and we will be obligated to buy stock. For this reason, we always set aside enough capital to fill the buy order. Proper risk management dictates that we assume we could be required to buy the stock and we are always prepared for this scenario.
2. This is why we only sell put options on stocks we want to own.
The put selling technique is designed to create income in our account, but only from an investment-savvy perspective. Since we know that there is a chance we will be buying the underlying stock, we only sell put options against stocks that we would like to own at a lower price. So if the put option is assigned, we are actually happy about the outcome because we were bullish on the stock in the first place.
3. This is why we set up our trades to buy stocks at a discount.
If our put option is assigned, this means two things. First, the stock has declined to a point where the price is now below the strike price of our put option. And second, we received premium for selling the puts, so our net cost is actually below the strike price. This discount pricing helps us start our investment well ahead of those who bought the stock outright at the same time we sold our put options.
Now that we have established that owning the underlying stock is a good thing (or at least should be a good thing if we set up the trade correctly), we need to determine how to handle our new position.
From a very broad standpoint, we basically have three choices. We can either sell the position immediately, hold for a rebound, or hedge the position.
Selling the stock outright doesn't usually make sense unless there is something that has changed between the time we sold our put option and when we actually took possession of the stock. But if you have a change of opinion on the underlying stock (maybe there is a fundamental shift in the company's business or a threat from a new competitor), by all means sell it.
The second option is to continue to hold the stock in hopes that it will rebound. This approach makes a lot of sense if you originally sold the put option on a stock with solid fundamentals in a stable trading range.
When holding onto a stock that has been assigned to you, it is important to set a risk point (or a stop-loss level) where you will bail out of the position if it continues to move against you. We need to make risk management our highest priority.
No analyst can fully account for every possible scenario that might happen to a company. So even if you do your due diligence on the company, there is still a chance that the stock could continue to fall well past the level where you expect traders to step in and support the price. For this reason, always have an exit plan. Remember, you can get back into the stock if it begins trading in a more attractive pattern later.
The final option with our new stock is to hedge the position. This approach is particularly attractive for accounts that are focused on generating income. Many times, I like to sell call options against a position that has been assigned to me. This is known as a covered call, and it helps to further lower the cost basis and add more income to my account. Then, once the stock rebounds, I will be able to sell it at a reasonable price (via calls that are exercised), and I will also get to keep the premium I received from selling the calls.
There are a lot of advantages to using the put selling strategy. When using this approach, it is very important to have a game plan in place so that you know how you will handle your position ahead of time. This helps you avoid making a rash decision when a position moves against you without fully analyzing all of the options available to you.
(This article originally appeared on ProfitableTrading.com.)