Investing

Let’s go a little farther down the put-option rabbit hole…

By Lee Lowell  |  June 6, 2018

As we continue to explore the amazing income-generating strategy of put-option selling, there’s something almost everyone asks me…

What happens if the stock drops below the strike price before expiration? Are we required to buy it then?

This is an excellent question.

As we know, executing a put-sell trade means that you get paid cash up front (the premium) in exchange for agreeing to buy a stock of your choosing at a price of your choosing (the strike price) for a time period of your choosing (the expiration date).

In most cases, the price where you choose to buy the stock is much cheaper than where it currently trades.

So, how are you able to fulfill your wishes of buying the target stock at a cheaper price if it’s much more expensive today?

Here’s the thing. You’ll only be called upon to buy the stock if it falls to your desired level (the strike price) by the option expiration date. If it doesn’t, you won’t get to purchase the shares. The premium, however, is yours to keep.

That’s the key to the whole strategy!

I choose stocks that have almost no chance of falling to our desired level. Sure, we won’t get to buy the shares on the cheap, but our goal is to generate income through the constant, continual collection of the up-front premium payments.

In the 10 years I’ve run my put-selling service, my readers have never had to buy any shares. Perhaps that’s unfortunate: many would’ve made for great long-term trades. But my readers have collected tens of thousands (and in some cases hundreds of thousands) of dollars in up-front premiums.

We target trades where odds of the stock hitting the strike price are minute. Of course, there are situations where the stock pulls back to that level before expiration day.

Which brings us back to the original question: Are we required to buy the stock if it hits the strike price before the option contract expires?

Technically, yes. Is it likely? Very slim.

Here’s why…

The put-option buyer decides the fate of the trade. They decide whether you’re forced to purchase the stock.

But a stock that goes down can also go up just as easily in the period before the option expires. If the stock were to recover after the put-option buyer forced you to buy the shares, they’d surely regret being underwater on the trade – and you (the winner) would have a nice profit!

So it makes total sense to wait until expiration day to see where the stock finally settles.

If you think about it, the put-option buyer bought the put option because they thought the stock was due for a fall. That means when stocks fall, put-option values go up.

That means the put-option buyer is holding something of increasing value as the stock drops. There would be no reason to force you to purchase the stock from them, as they can just as easily sell the put option back to the market for the going rate and lock in their profits.

Here’s another big reason why it’d be foolish for the put-option buyer to force you to buy the stock before expiration: the loss of “time value.”

What’s that?

This concept is a big deal in options trading because it’s the portion of an option’s value that’s derived from the volatility that exists in the market and how much time is left before expiration.

Yes, there’s some fairly complex math at work here, but it’s easier to understand when you think about it in terms of money. Bear with me.

Once a put-option buyer forces you to buy the stock before expiration, they forgo the extra money they could have received if they had sold the option back to the marketplace.

Since most option traders are smart and realize this, they won’t force you to purchase the stock just because the stock price happened to fall below your buy-in level. Selling the option is the more intelligent move.

In all my years of trading put options, it’s been my experience that 99.9% of all trades are settled on expiration day.

Of course, there’ll be that one trader out of a thousand who doesn’t understand the nuances of option trading and exercises the option before expiration. They’re in that 0.1% of “dumb” option traders.

So, although you do need to keep the risk of early assignment in the back of your mind, the real chances are almost nil.

Soon, I’ll share some other great option-trading techniques that are sure to have you wondering why you would trade traditional stocks at all.

Until then…


Lee,
Editor, Instant Income Alert

Lee Lowell

A former Wall Street insider and floor trader, Lee Lowell has worked in the market for nearly 30 years now. He began his option trading career in 1991on the floor of the New York Mercantile Exchange (NYMEX) in New York City.MORE FROM AUTHOR