Buying puts on the financial select sector SPDR multiplied recently as the government entered into consideration of new regulations. Puts to sell outnumbered calls to buy by roughly twenty to one as the SPDR fund price fell nearly two percent, to just above $14 a share. The huge difference has arisen as congress is debating the final terms of new regulations for the financial industry. Poor oversight and banking sector excesses are commonly blamed as major causes of the 2008 market crash. However, many banking insiders are concerned that the upcoming restrictions will damage the financial industry as it tries to get on its feet again. An example of the proposed regulations is that banks may be restricted from trading derivatives. SPDR funds are shares of a family of exchange-traded funds (ETFs) traded in the United States. These funds are managed by State Street Global Advisors. The acronym SPDR comes from the first ETF in the fund, Standard and Poor’s Financial Services Depository Receipts which is designed to track the S&P 500. These funds are set up as unit investment trusts. The financial select sector SPDR a range of financial service firms including JPMorgan Chase, Wells Fargo, and BankAmerica Corp. With new regulations on the way it may be bad times for the financial sector but times of volatility are good times for trading options.

The kinds of options trading that are most profitable will depend upon what the market in the underlying equity is doing. Put call ratios are running around sixteen to one on individual stocks across the financial sector as traders fret over the consequences of tougher regulations on financial sector profitability. Traders buying calls is a sign of faith in the likelihood of stock prices going up. Traders buy puts in the belief that a stock price will go down. If the large majority of traders buying puts are correct then they will be able to sell Financial Select Sector SPDR shares at the strike or contract price at a time when the spot price or market price has dropped substantially. Traders will buy at the spot price and sell at the strike price, pocketing the profit. Traders believe that buying puts on the financial select sector SPDR will lead to profits.

As usual we are not suggesting buying puts on the financial select sector SPDR or buying calls for that matter. This is an exercise in watching market indicators such as the daily put to call ratio and using that information to find advantageous situations for uncovered options trading. When a trader sees a great deal of market volatility but does not know which way the market will go he or she may engage in a long straddle options strategy. In this strategy the trader will buy a call and buy a put on the same equity with the same option expiration date. This strategy costs the trader two premiums but insures that he or she will profit no matter which way the equity price goes. The only way to lose on a long straddle is if the market quiets down and the equity price remains stable. In that case the trader is out the cost of two premiums. If the trader really believes that the equity in question has stabilized then selling both puts and calls can be profitable. This is a short straddle. The profit is two premiums if the equity price does not change but the loss can be substantial in either direction if the price moves dramatically. The point of being aware of the fact that the market is buying puts on the financial select sector SPDR is that knowledge properly used leads to profits in options trading.

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It is always wise to practice risk management in options trading. In the case of writing puts in options trading it is important that the put seller or writer be very sure of the trend of the underlying stock. The profit from selling puts lies solely in gaining the premium when a previously volatile stock stabilizes or a stock on its way up does not correct, as the buyer of the put think possible. 

The risk of writing puts in options trading is that the underlying stock will fall in price and that the buyer of the put will exercise his or her option. In that case the amount of loss for the option writer will be the amount that the stock drops in price below the strike price multiplied by 100 shares for each contract written. The potential loss is the entire value of the stock. Thus this options trading technique should be reserved for those with substantial experience in options trading and in depth knowledge of the stock involved. It all has to do with predicting the future difference between strike prices and spot prices in options trading. 

The trader needs to ask himself or herself when is trading put options a good option? For the owner of a stock that has gone up dramatically buying put options on the stock insures against a precipitous correction. There are individuals who were not wiped out when the dot com bubble burst because they used exactly this technique. They bought put options on their stock. Those who believed that writing puts in options trading on the same stocks did, in fact, suffer serious financial loss. 

If put writing were always incredibly dangerous no one would ever write puts and no one would ever be able to buy puts. But, these options contracts are bought and sold. When trading options in relatively stable stocks the risk of selling puts is substantially offset by the premium paid. For someone with intimate knowledge of the underlying stock this options trading technique can be a recurrent money maker. This individual may well be a person who is making a living trading options which means they have the time to devote to detailed study of appropriate stocks and market conditions. Writing puts in options trading is probably not a options trading technique that should be used by someone who engages is occasion options trading. When writing puts it is all important to know the underlying stock and its market sector very well. It also important to have sufficient capital reserves in case of loss.

Some years back Amazon.com was considered by many to be a good stock for which to sell a call option.  Options trading in Amazon.com was often successful because the stock went through a number of cycles which, to a degree, became predictable. Thus, an owner of Amazon.com could wait until the stock was at the top of the cycle and then sell a call option. The stock would not go up so the owner retained the stock and gained a premium. He or she could sell a call option on the stock each time the stock reached the top of its cycle.

To sell a call option means that you sell the right but not the obligation to buy a stock. Typically it is a stock that you own, as in the above example. If the stock goes up the buyer of the option exercises the option at the strike price, which is the original price of the options contract and owns the stock at the spot price, the current market price. Selling when you own the stock is called a covered call and selling when you do not own the stock but firmly believe it will go down in value is a naked call. To sell a call option naked is the business of full time traders who can watch the underlying stock closely. If you business does not let you follow the market all that closely you only want to sell a call option when covered, that is, when you already own the stock.

The risk of this kind of options trading, to sell a call option when covered, is that if the stock breaks out of its cycle to the upside you lose out on the gain, retaining only the premium. But, for the longer term investor who does not have the time or expertise to engage in full time options trading, to sell a call option on occasion can be profitable.

Another example of occasional options trading that can work is with an investor who gets into a growth stock early and sees his or her investment multiply in value. The investor is concerned that the stock will “correct” and wipe out a large fraction of his or her gains. However, he or she does not want to sell the stock as the investor believes the stock has the potential to go up farther. Options trading can help in this situation. The investor can buy a little insurance, so to speak, by choosing to buy a put option.

Unlike when you sell and call option and someone else has the right to buy the stock, when you buy a put option you are buying the right, but not the obligation, to sell the stock at the strike price, the price of the stock at the beginning of the contract. If the stocks drops precipitously your insurance pays off and you exercise the option. If the stock does not move you have paid a little insurance in the form of a premium and still retain your stock. If the stock goes up you have a potential profit, minus the insurance value of the premium. To buy a put option when you own the stock works when you expect a volatile market and want to insure against downside risk while preserving upside possibilities.

What is a put option and when does a options trader buy or sell put options?

When an options trader thinks that a stock will go up in price he could buy the stock or, for much less, sell a put. When the trader sells the put option he or she receives a premium and undertakes the obligation to buy the stock at an agreed upon price, the exercise price or strike price if the buy wishes. If the price of the stock goes up the buyer of the put will not want to sell and the seller of the put will gain the premium.

If, on the other hand the stock price drops the put buyer will want to exercise his right and the sell will have to buy the stock at the exercise price when, indeed, it may be worth substantially less. Selling a put when one does not have the cash to cover a loss is called an uncovered put or naked put. The downside potential on an uncovered or “naked” put can be the exercise price of the stock if the stock itself goes to zero.

Options traders can buy and sell puts. Buying a put is often a defense strategy for the owner of a large stock position after a substantial run up and a very volatile market. Buy paying the cost of the put the stock owner protects his or her position against substantial loss. Because the buyer of the put is under no obligation to sell his or her stock he or she can pay a little “insurance” to protect a stock position against loss and still control the stock if the price, in fact, goes up.

More complicated approaches to put options are approaches such as long straddles where the options trader will purchase both a call option and a put option on the same stock at the same strike price. The options trader can make money if the stock moves substantially in either direction, and will only lose the price of the options if the stock stands still.

In the case of buying and selling put options a stock owner may be protecting a stock position or a stock trader may be looking to leverage a small amount of capital into a large gain such as with a long straddle. In the case of selling a naked put the options trader is betting on gaining the premium and not losing his or her shirt with a precipitous drop in the stock price.