Sell a Put or Just Buy the Stock? Tom Preston Shows You the Math

AMZN

Selling an out-of-the-money put on Amazon (AMZN) with a strike price of 220 provides a bullish bias and allows the trader to potentially buy the stock at a lower price (220) if the stock price drops below the strike price at expiration. The premium received ($5.80) reduces the effective cost basis to $214.20. If the stock price remains above 220 at expiration, the put expires worthless, and the trader keeps the premium. If the stock price drops below 220, the trader is obligated to buy the stock at 220, which is cheaper than the current price of 240. This strategy is suitable for traders who are bullish on AMZN and want to give themselves a better entry price while earning a premium.

AMZN

Selling a put with a strike price of $220 on Amazon (AMZN) provides a potential return of 20% on capital if the stock remains above $220 at expiration. The strategy involves selling the put to capture the premium, which is $585, and waiting for the stock to rally. The return is calculated as the premium received divided by the capital used. The risk is that the stock could drop below $220, resulting in a loss. The strategy is suitable for traders who believe the stock will not drop below $220 within the 52-day period.

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When volatility is high and put prices are inflated due to dividend expectations, selling out-of-the-money puts can provide a return on capital. The put price reflects the dividend amount, allowing the trader to capture some of the dividend value without owning the stock. However, the trader forgoes the entire dividend, and the strategy is less capital-intensive than buying the stock directly. This strategy is suitable when the trader is comfortable with the risk of the stock price dropping below the put strike price.

Using Out-of-the-Money Puts for Lower Entry Prices

Selling an out-of-the-money put allows traders to potentially buy a stock at a lower price than the current market price, while also earning a premium. This strategy provides a bullish bias and can be used to give oneself more time to assess the stock's performance. The cost basis is adjusted by subtracting the premium received from the strike price, effectively lowering the entry price. However, if the stock price drops below the strike price at expiration, the trader is obligated to buy the stock at that lower price.

Return on Capital for Short Puts

Selling out-of-the-money puts can provide a return on capital depending on the stock's movement. The return is calculated as the premium received divided by the capital used. For example, selling a put with a $22 premium on a $240 stock gives a 10% return on capital if the stock remains above the strike price at expiration. The return can vary significantly based on the stock's price and the strike price chosen.

Dividend Impact on Put Prices

The presence of a dividend increases the price of out-of-the-money puts, as the put price reflects the dividend amount. This is due to the delta of the put multiplied by the dividend amount. For example, a $1 dividend with a 36.36 delta results in a $0.36 increase in the put price. This mechanism allows short puts to capture some of the dividend value, even though the trader forgoes the entire dividend by not owning the stock.

What is the purpose of selling an out-of-the-money put?

Selling an out-of-the-money put allows traders to potentially buy a stock at a lower price than the current market price, while also earning a premium. This strategy provides a bullish bias and can be used to give oneself more time to assess the stock's performance.

TakeawaySelling an out-of-the-money put can be a useful strategy for traders who are bullish on a stock and want to potentially buy it at a lower price while earning a premium.

What is the return on capital for selling a put on Amazon?

The return on capital for selling a put on Amazon is 20% if the stock remains above $220 at expiration. This is calculated as the premium received ($585) divided by the capital used.

TakeawaySelling a put on Amazon with a strike price of $220 can provide a 20% return on capital if the stock remains above $220 at expiration.

What is the impact of a dividend on put prices?

The presence of a dividend increases the price of out-of-the-money puts, as the put price reflects the dividend amount. This is due to the delta of the put multiplied by the dividend amount. For example, a $1 dividend with a 36.36 delta results in a $0.36 increase in the put price.

TakeawayTraders should consider the impact of dividends on put prices when evaluating their strategies.