Selling an XOM Put Option

While I don't own XOM in the Chump IRA, I do own it in my taxable account.  I worked at Exxon in the mid/late nineties, and have owned shares ever since.  The point is, its a great company, and I follow the news and price movements of the stock.

Looking at a price chart for XOM the past six months,

you'll notice that the price is really down in October, hitting a 52 week low.  With the price down for all the major oil & gas companies, and the budget impasse hitting all stocks, I was thinking about adding more XOM shares on weakness.  I had cash available in the IRA from the recent sale of my FDO position (earlier blog post), so why not.

Then I read an article by Dr. Paul Price on his Market Shadows site, talking about XOM puts, which inspired me to give it a try.

I've bought puts in the past on stocks I think are extremely overvalued, betting they will decline before my put expires.  I've had mixed success.  They can also be a useful hedge, increasing in value during a market decline.  But until now, I've never sold a put.

I pulled up a list of put options for XOM.   Here is where it gets a bit confusing.  If you sell a put option, the buyer pays you a fee to own the option.  You collect the fee, the buyer has the right to sell you shares of the security in the future for the option's strike price.  The buyer of the option will exercise his right to sell you his shares only if the price drops below the option strike price.  The buyer is betting that the price of XOM shares at that future date will be lower.

From my perspective, I sold the buyer this option.  He paid me for the option (called the option premium), and in the future, if he excises that option, I must buy the XOM shares at the agreed price.

Here is the actual transaction example:

• I entered the symbol XOM, then called up the associated options chain
• I searched for all PUTS
• I scrolled though the many expiration dates, and found one out in 2015
• The share price at the time for XOM was around $84.75 on the day of the trade
• I selected a 2015 put option with strike price of $85, and an option premium of $800
• I then selected this verbiage:  "Sell to Open" 
• I placed a market order for 1 contract, and the order was filled immediately

My IRA cash balance increased by $800 immediately following the trade, less a $7.95 commission.

If the price of XOM stock goes up, or stays above $85 until the expiration date in 2015, the option will not be exercised, and I keep the $800.

If the price drops below the $85 mark in 2015, the option is exercised, and I lose only if the price is below ($8,500-$800)/100 = $77/per share.  Below $77, I lose the difference x $100.  

If XOM goes bankrupt, and shares go to $0 by 2015, I lose $7,700 - this is my maximum risk.

Over the subsequent several days, the price of XOM went up and down, but mostly up.  As the price rose, the value of the PUT option I sold declined (to the buyer).  As the price was going up, the likelihood of the buyer exercising his option for shares at a lower price than $85 began to decline.

A few days later, the market was down a few hundred points, and wanted to add some shares of SO, IBM, and VMI.  Unfortunately, my account rejected the trades saying there wasn't enough cash available in my account... Aha!  That was when I learned the downside to selling puts;  the one contract for 100 shares of XOM at $85 ties up exactly $8,500 until the option is exercised in 2015, expires in 2015, or is bought back by me, effectively closing out the position.

So if XOM continues to rise in price between now and 2015, I'll lose money on the option if the price ends ($800/100 shares)= $8/share higher, or at $94/share or more.  Dang, this seems like a bad bet to me, so my next move was to close the position.

Here are the actual steps:

• Next to option listing in my account, selected trade
• Chose the following verbiage: "Buy to Close" and selected
• Chose 1 PUT contract
• Chose market order, and hit submit
• The order executed immediately

Because XOM was trading higher on the day of the trade, around $87/share, the put option was worth less, approximately $720, so I paid $720 to buy back the put option, closing the position.  I made $80-$15 (commissions) = $65 on the round trip, and freed up my $8,500 to invest.

Sometimes the best way to learn about these things is to actually make the trade.  Based on my learnings from this experience, it doesn't seem like a great strategy it ties up chunks of cash for long periods.

Thats all for now,

Chump