A Put Primer

There was a lot of stress this week over the sale of puts on Abercrombie and Fitch.

Most of the stress was by me. Not because of the ridiculous price action, which is standard fare for these shares, but because I had to figure out how best to track the outcome of the trade when some people. including me had early assignment of the puts, while others did not and were heading toward assignment at the end of the day.

That also means different trading strategies because some would potentially have shares in hand upon which to sell calls today, while others would be faced with the decision to either roll over the puts or await assignment and hope to be able to sell calls on Monday.

The problem with that latter is that it’s hard to predicate anything on a hope, especially since today was an ideal day to rollover the puts as ANF had a large share gain intra-day. Who knows what Monday brings?

My guess, but that’s all it can ever be is that if the market is sound next week ANF will make up some more ground in advance of its earnings report on November 21, 2013.

Between the known fact that shares were stronger today and the unknowns awaiting next week, compounded by what ridiculous more news may come at earnings makes the gift horse especially appealing.

Later I’ll show you why improving price was important using some screenshots I took during the day while following shares looking for opportiunities.

But since this is a primer, let’s start at the beginning.

To start, a put is an option contract that when bought is a statement that the buyer expects the shares to go down in value, in which case the value of his option will increase.

The buyer typically wants to trade in and out of option positions, because their money is greatly leveraged. They don’t usually want to be assigned and have to take over ownership of shares.

The put seller is usually the more bullish participant in the trade. They think that the shares may go up or down, but if they go down they’re not likely to go below the strike price. The big caveat is that put sellers should be willing to own the shares just in case they are assigned and they end up owning them, as happened to me and a small number of other subscribers.

In the case of Abercrombie and Fitch its shares plummeted on the day before their planned Analysts’s Meeting, the first they had held in over two years.

On the evening before that meeting they presented revised guidance and it wasn’t very good news. I hate revised guidance, even when it’s good. There’s no way to prepare for it unless you have inside information.

I almost purchased shares in the after-hours, but decided to wait until the next day.

At first, when trading started I was upset for having waited as the price significantly improved but was still low enough to seem to warrant a position. However, just to hedge, I decided to use an out of the money put in anticipation of some continued price drop.

As an aside, but an appropriate one, I think the current market may be an appropriate one for the use of more put sales rather than initiating new positions and covered calls. That’s simply an expression of a bearish sentiment. Even though I’ve been cautious and have kept cash reserves, I’ve not used the SOS strategy as a further expression of bearishness, but I think there may be a greater role for put sales now.

Obviously, understanding them is requisite for their use.

But, back to Abercrombie and Fitch. Thanks to the utterings of the CEO, who is not terribly regarded as a person, due to his rather odd behavior and opinions,  shares suddenly went much lower during mid-day trading and then everyone on television just piled on. If you ever have any doubt about the power of basic cable television, just watch the ticker and price changes as specific stocks are discussed, especially when event driven. But even then, the continued drop surprised me, thinking that an additional 2% drop was enough of a cushion after an already 5% drop in shares.

So shares dropped even more. Normally, the escape strategy when having sold puts that are now in the money is to simply roll them over at the same strike price, assuming you continue to be reasonably bullish. Otherwise, you can roll down to a lower strike price, but that will cut into your net premium, perhaps even causing a “net debit” from the transaction.

However, Abercrombie and Fitch made any kind of transaction difficult because the more it was in the money the less became the time value of the contracts, being instead made up almost entirely of intrinsic value, that is the difference between the strike and the current value. To make it worse, there was a large gap between the bid and ask prices.

The net result was that at one point earlier in the day a rollover trade would have resulted in incurring a Net Debit.

You don’t want a net debit. You would prefer to make money, even if it’s not that much money.

In this scenario you would have still been obligated to buy shares for $35.50 a week later, but it would have cost you $0.20 of your earlier option premium profit.

As long time subscribers know, I have patience.

In this case the patience was measured in hours and not option cycles.

 

 



 

In the meantime, though the price of shares started recovering in the late morning, the Net Debit went only to break-even.

The differential between the expiring contract and that of the next week  saw naturally more erosion in the expiring contract as price moved in a direction toward the strike price. Obviously, that’s not something in your control. It’s just a measured risk, knowing that even if nothing is done you’ll end up with shares in your account on Monday morning and then just do with them as is done with every other holding.

But simply being at break-even is fine if the brokerage is your uncle. Otherwise, it’s not very satisfying.

 



Then it went to a Net Credit.

Bingo.

That’s what you want. In fact, you can see from the timestamp on this image and the previous one, that even though the price of shares was more favorable earlier, the premium differential actually improved as the clock was ticking, even though shares moved away from the strike.

 

 

 

  

The problem was that the bid-ask spread was still on the large side, leaving only a small net profit

Here’s where it’s helpful to look at the call side of things.

Even though pricing isn’t always rational, it’s reasonable to expect that whatever irrationality there is would be equally distributed between call buyers and put buyers.

Hard to prove, but equally hard to argue.

On the call side of things the equivalent trade, that is selling the November 16, 2013 $35.50 call was yielding a bid of $0.18 with a more normal differential between bid and ask.

So in placing a trade to rollover the puts, rather than using the bid on the sale and the ask on the purchase (as outlined here), for a Net Credit of $0.08, use an intermediate figure determined on the call side of the aisle.

For those that haven’t owned Abercrombie and Fitch in the past, it is a stock that can be very rewarding with a modicum of patience and has been ideally suited for a covered option strategy, but all in all I would much rather see put sales expire and simply decide whether I want to pursue the stock on my own terms the following week, as was recently done with Coach, another company that takes big price hits, but always seems to work its way back into good graces.

In general, if your put sale shares are just slightly in the money you are usually much better off simply rolling over the puts just as you would normally rollover a call position sold on shares that you own.

Unfortunately, I don’t have it documented with screenshots, but for my personal trades some of you may have noticed that I’ve been doing that with the ProShares Ultra Silver ETN (AGQ) speculative hedging position. In this case using a $20 strike price I haven’t really cared too much whether the price was above or below the strike. I just allowed events to dictate whether rolling over when expecting a price increase in silver or sitting on the sidelines when expecting price increases. As with stocks, it’s all about being able to do the trades on a serial basis and watching the premiums add up.

When history repeats itself it can be a beautiful thing.

If this is your first foray with Abercrombie and Fitch I believe that this is a good price at which to do it over and over again, whether through the sale of puts of through the use of covered calls.

I’ll leave the personal feelings about the CEO to others, as long as there is a way to milk some dividends from this pig.