Selling cash-secured puts on stocks you wish to hold for the long-term is a fantastic way to build core positions at an attractive price with lower risk than an outright purchase of the desired stock, while increasing your yield and reducing your cost basis.
1. Definition. A put option gives its purchaser the right to sell a stock at a given price (strike) during a certain period of time (maturity). Conversely, the seller of a put option has the obligation to purchase the stock at a given price (the strike) if the put is exercised before the end of a certain period of time (maturity). The seller is compensated for this obligation by receiving money at the time the obligation is assumed (i.e. the put is sold). This premium is a function of 6 variables: the current underlying stock price (the spot), the strike price, the maturity, the implied volatility of the stock, the dividend of the stock, and interest rates. The seller keeps the premium whatever happens, unless he decides to buy back the put at a later date to be relieved of its obligation. The timing of put selling is therefore important: a seller will want to write the put at a time where the premium will be inflated by a spike in implied volatility for instance. See also the VI main Commendments of Put Selling.
2. Main Benefits.
- Generate income on your cash and puts the odds in your favors (around 80% of options expire worthless)
- Getting paid to while waiting for an attractive entry price for stocks you want to hold
- Reduce risk compared to outright stock purchase
- Forces you to buy low
3. Possible outcomes. Rightly choosing the stocks on which you wish to sell (write) puts is absolutely paramount to control risk. Indeed, the only risk in selling put is to be put the stock at a price that is higher than the stock price at the time of the exercise. This translates to a paper loss that would be dimished by the premium pocketed when the put was sold, and that would be temporary if the stock is solid and eventually bounces back. As a matter of fact, you may start to realize that the siutation is exactly where you want to be as it would allow you to acquire stocks of a great company at discounted prices. Let’s have a look at this through an example:
Intel’s stock (INTC) closed at $26.33 on August 17, 2012 and is down amost 10% from its early May peak. Intel is a market leader with a wide economic moat and strong management and at this level, INTC is trading at a P/E of 10.6 and yield 3.4%. Its weighted dividend growth rate is around 11% and its Dividend SCORE is 78. Arguably, dividend growth investors may well consider INTC a solid long term buy at the current price.
But instead of purchasing 100 shares at $26.33 for $2633, what about selling one put and getting paid for waiting to get into INTC at a discount price? One could for instance sell a January 2013 put with a strike price of 24 and pocket the premium of $0.80 per share. One put controls 100 shares, so the seller would receive $80 and be requested to hold $2400 in cash to be able to purchase the shares if the put is exercised. From here, there are two main possible outcomes:
- The stock price stays above $24 until expiration of the option. The put you sold expires worthless and you keep the $80 premium received when you initiated the trade. This is a 3.33% return in only 5 months on the $2400 in cash you kept in your account. This equals to an 8% annualized return on your cash! Note: in a margin account, brokers often only request that you hold only 50% of this amount, thus making the put sale even more profitable.
- The stock price dips sufficiently below $24 for the put to be exercised. In this case, you become long 100 shares of INTC at $24, and taking into account the premium received from the put sale your cost basis in the stock is $23.20 per share, which represents a 12% discount compared to the current stock price of $26.33. If at the time the put is exercised the stock trades at $22, of course you have a paper loss of $120, but this is much less than the $433 loss you would sit on had you bought the stock at $26.33. You have also locked in a 3.9% yield-on cost compared to the current 3.4%.
4. Position Management.
During the life of the trade, you will still have the opportunity to adjust to market developments and/or potential fundamental changes in the underlying company. These adjustments can be put in two broad categories:
- Closing the position: since you sold the put, the stock price has risen, volatility has dropped, and/or time has passed. As a result, the premium of the put has come down significantly and it could make sense to lock-in your profits and move on. For instance, if the put premium were to drop to $0.1 by mid-November, you could buy it back and net a $70 profit, i.e. a return of 2.9% in 3 month, or around 11.6% annualized.
- Rolling the position: you can roll a position farther in time (increasing the premium received) and you can roll a position down (buying back the initial put and selling one with a lower strike price) or up (buying back the initial put and selling one with a higher strike price). In many cases, especially if you initially sold the put in the right circumstances, you will be able to roll your position at a profit even if the stock does not move as initially expected.
Finally, this strategy can be used not only to initiate a long position in a stock, but also to continue reducing your cost basis: indeed, once you have a position in the stock, you can continue to sell puts below the current price to avergae down in case the price drops. Once again, it is all about rightly choosing your strike price, timing, and above all the stocks on which you sell the puts.