Friday, April 13, 2007

Selling Puts: A Great Way To Add To Your Returns

So lets do some basics. What is a "put"? Simply stated, if I buy a put. I am buying the right to sell somebody shares of a stock at a predetermined price on a certain date. You can get another definition from Investopedia here. For example, I buy a MO April $70 put. What that means is that I have purchased the right to sell 100 shares of MO to the seller of the put at $70 per shares if the price of MO drops below that during the month of April. When you buy a put, you profit when the price of the stock the put represents falls. When you sell a put, it is just the opposite.

This is very different than the "covered call" strategy most people have heard of and use when it comes to options. In the covered call scenario, you sell someone the right to "buy" your shares at a predetermined price that is usually higher than your purchase price, guaranteeing you, the seller a small profit should they get "called" the shares. This strategy is popular because if the investor gets "called" their shares, they sell them at a profit and if they aren't, they keep the option sales price (called a premium). I personally dislike this strategy for two reason.
  • I do not like to sell the stock of a company I own unless there has been a deterioration of it's business or fundamentals.
  • There are tax implications that are not usually considered that dramatically reduce the returns the covered call seller actually realizes.
  • Too often this covered call strategy has the effect of "capping" profits, meaning the seller of the call ends up selling their shares prematurely at a lower price than they could have gotten on the open market
As I have said before, the buying of options is a very risky strategy and I rarely if ever do it. They tend to be short term transactions and as we have discussed previously, the shorter you time frame in an investment, the greater your risk. Another reason is that if the transaction turns against you, when you own an option you must then either sell for a loss or lose everything you invested because options, when they expire, are worthless. You essentially are stuck with the decision of either losing a little or a lot. If you buy stock and it turns against you, you can at least hold it until the stock turns around. Options have a time element that stocks do not have and that makes them inherently riskier.

I quite often engage in the selling of them though. Why? If I am selling a put in the way I usually do it, I transfer this time element risk to the buyer and by doing that, have very little risk in the transaction. Let me explain.

In the ValuePlays Portfolio I currently have sold puts on 2 companies we own stock in and one we will. Let me explain why I do it and how it helps our returns. I am going to use the Altria (MO) and Peabody (BTU) puts we have recently sold as examples. First Altria:

The main parameters I use in selling puts are:
  • Only sell them in companies I want to own shares of stock in. That way, if the strategy goes against me and I am "put" the shares (forced to buy them) I at least now own stock in a company I want to own.
  • Only do this when the stock is in a price range in which I would consider buying shares in the open market at. Again, this way if the strategy turns against me and I am forced to buy the shares, I am paying a price for them I am comfortable with.
By doing it this way, I have virtually no risk in the option transaction because even if the "worse case" scenario happens and the price falls and I am put the shares, I own them at a price I was willing to buy them at on the open market anyway. The case could be made that in doing it this way, I am assuming Less risk than if I had bought them in the market in the first place. By doing it in this manner, if I end up actually owning the shares, it will be at a lower cost basis than if I had just purchased them initially. I only assume risk here if I am selling puts at prices I believe to be too high for the stock in the first place. This is an important point because this is part of an"investing strategy" not a "trading" one.

The argument could be made that I assume the risk of not owning the shares at all if the price goes up. In that case, I keep the premium price from the buyer and just miss out on owning the stock. I am fine with this because it means the riskiest part of this strategy is only making a little money. I will take this risk every day.


On 4/5 I sold an April $70 MO put with Altria shares trading at $70.45. That means that if the price of MO falls below $70 before the option expires on 4/19, the buyer of the put can sell me 100 shares of MO at $70. If the price of MO ends up above $70 at the expiration date, the option expires worthless and I keep the money the buyer paid for it. In this case, the buyer paid me $70 (70 cents a share) for each put he bought from me.

Let's say the price of MO finishes below $70 at the expiration date of 4/19 at $69.50. I now have to buy the 100 shares from the buyer at $70 each. Bad news? NO. Why? Because I have already received 70 cents per share for the puts. This means that if I am forced to buy the shares my actual cost is $70 - $ .70 = $69.30. This means that as long as the price of MO shares do not drop below $69.30, even if I have to buy them at $70, I have profited from the transaction. If the price of MO is above $70 on 4/19, then I keep the $70 as pure profit and probably sell more puts for next month.

Yesterday (4/12) I sold BTU April $45 puts for $90 for each put. I do not own BTU yet but want to. These puts expire next Friday, April 19 (all April puts and calls expire at the same time). When I sold them, BTU was trading at $45.85 a share. In this case, the price of BTU needs to fall below $44.10 ($45 - $.90) in order for this transaction to be negative if I am put the shares. In this scenario, I am put the shares but own them at a price below what I would have bought them at today anyway. If the price settles above $45, I keep the $90 per put as profit and sell more next month (currently these sell at $145 per put). Now, let's say that BTU closes at $46 and I do not get put the shares. At expiration I will immediately sell more puts for May. For easy math, I get $100 per put ($1 a share). BTU now needs to close below $43.10 ($45 -$1 (May put) - $ .90 (April put)) for this to become a negative transaction. If BTU closes at $44 a share and I am put the shares, I in essence enter my ownership of BTU shares already up $.90 or 2%.

How can this help our overall returns? As of my writing this Thursday afternoon The ValuePlays Portfolio is up 8.5% YTD (since inception1/18). Without the put selling strategy, it would have been up 8% YTD so in 12 weeks this strategy has added .5%. Not a huge difference but when you consider we started the portfolio 1/18, doing this can add up over the course of the year. The big take away is that this is done with very little risk.

Options can be very confusing and dangerous if you are not sure what you are doing when you do it. There are no "do overs" here. Be sure you have a good grasp of what you are doing before you push the button. Feel free to email me at if you have questions.

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