Writing TSM Put Options: Why Choose Front Month?

Don Y. asks on 12/31/10

Hi Ric,

I am new at writing Puts. I have a concept of how options work, but am no expert at all. That's why I really want to ask you something that I find perplexing. I'm sure you have a good explanation.

For example, on SWKS's Put that you recommended on twitter lately, why not sell it back in Nov when it was above $2? On the surface, that looks like it offers better protection against losses and would be more profitable, but I'd like to hear your reason for selling it at the time you recomended it, since the pattern seems to be consistent in all your options recomendations. Thanks.

Regards,

Don

____________________

Don,

I haven't recommended SWKS for a TSM trade. So far as TSM Puts go, I present two types of information on twitter:

(1) actual trades that I've made, which are labeled by a Trade #, and (2) possible TSM trades that meet our trading

criteria. The latter is how I presented SWKS. I only track the first type trades at the TSM website.

As to actual Put trade characteristics with respect to time and % downside protection, those choices are made based

on an annual return criteria (>18%) and % downside protection (from 5-15% depending on time to expiration.

Your question is: Why not go further out and collect a bigger premium?

Let me answer that with a hypothetical position: $50 stock with 40% implied volatility, 1% interest rate and no dividend (all these impact the level of premium according to the Black-Scholes equation). The immediate calculated Put premium for a $45 strike is just a function of time to expiration, e.g., for 10 contracts, assuming that price doesn't change, then

....($50 strike price and $45 Put)

150 days = $2,675 30 day delta $445

120 days = $2,230.....".............$495

90 days =...$1,735.....".............$565

60 days =...$1,170.....".............$650

30 days =...$520........".............$520

Every option experiences its greatest loss of value percentage wise in its last 30 days (100% loss) versus

any other 30 day period, e.g., from 90 to 60 days, the above option would have lost 32.6% of its value.

I choose ~30 days expiration (front month) to maximize the time decay and, at the same time, reduce risk.

Having made the above argument, I could choose a longer expiration--as you indicated--for a larger premium

with an aim to close that position after 30 days, for example, if the above stock remained at $50, one would

have made more money by selling the 60 day Put then closing it at 30 days ($650 vs $520). That's true, but the

risk situation is much worse. Remember I want to protect the downside.

Say during the 30 days, the stock drops in value to $45 (the Put's strike price), and I close the position. Here's

what my profit situation would look like for the various Puts:

($45 stock price and $45 Put after holding position for 30 days)

150 day Put at 120 days $4,028 loses -$1,353

120 day Put at 90 days $3,500 loses -$1,270

90 day Put at 60 days $2,869 loses -$1,134

60 day Put at 30 days $2,038 loses -$865

30 day Put at 0 days $0 gains +$520

I choose the front month to minimize risk. The TSM stocks are fundamentally

sound with value left in their price. Most will experience a rapid price rise

(~70%) and I'll close the Put position early (usually when 75% of the premium has been

captured, and there's more than 2 weeks before expiration) to capture more premium

in another stock for those 2 weeks. The above Put strategy protects me in those 30%

where I'm wrong and price drops. Note, before I exit a Put position, I calculate the

return that's left given the premium drop. If it's greater than 18% annualized, I continue to

hold the position.

Hope this helps,

Ric Miller, Ph.D.
6-Sigma, Master Black Belt