Fri Oct 13, 2006: Free Options -- Sell Calls and Buy Puts

Bearish option investors who want to place a downside bet, but are hesitant to pay for it, can get a "free trade" by using premium received from selling calls to finance the puts they buy, with zero net cost.

For example, the stock of Google, Inc. (NASDAQ-GOOG) closed today at 427.30 and November 400 puts were last offered at 8.50 which is $850 per contract, not exactly cheap. Wouldn't it be nice to buy those puts using money we receive from another speculator?

Let's assume that GOOG will stay below 520 between now and January 2008, a 15-month period. If that's correct, then by selling one January 2008 520 call option we could get enough money to buy puts like those Nov 400's five times for free during that period. If we can't get our timing right with that many chances maybe we should forget options and take up poker!

As a practical matter, we still must put up the initial naked call margin requirement and pay for the initial cost of the puts we buy. But if we are correct on our assumption, the $4,130 income from selling the 520 call will be ours to keep when that option expires on January 18th, 2008. So we could buy a put for approximately $800 five times for various months over the next year, and even if they all expire worthless we wouldn't lose anything.

You don't have to wait until expiration to sell your put, you can do so at any time prior to expiration. If the stock takes a sharp drop one day, even if it doesn't go below your put strike price, you will have an opportunity to sell your put for a nice profit. In that case, you could then wait for a substantial bounce in the stock before buying a put again, not necessarily at the same strike price and month each time.

Of course there is risk that if the stock does not go down as you expect, you could lose all of the money you paid to buy each put, if the stock finishes up above your put strike price each expiration day. Also, the risk of selling the naked call is unlimited if the stock goes up above your call strike price and keeps going up.

Until next time, best of luck with your option investments!