This article is second in series for understanding options. The target audience are long term value investors. The first part of the article can be found below.
Option I: Introduction and pricing
In this part we will discuss one of the best strategies out there for long-term investors. This is writing puts to purchase stocks at a discount.
What is writing a put?
Remember from the first part that a put is an instrument which gives the buyer of the put the right but not the obligation to sell the security at the strike price. For example, let us take a Berkshire Hathaway (NYSE:BRK.B) put for $65 expiring in January 2013. The buyer of the put has the right to sell the BRK.B security to the seller of the put at the strike price of $65 a security until January 2013. What this means is that the buyer of the put will make money if the price of BRK.B goes below the strike price (ignoring the commission). The lower it goes, the more in-the-money the put is. The price of the stock on the other hand can go both up and down. Let us consider each case and see how it effects the seller of the put (in this case a long-term investor).
- If the price of the stock stays above the strike price, i.e., $65 in this case then the put has no value. What this means is that there is no incentive for the buyer of the put to sell the stock at $65 when he can already sell it in the open market for more than that money. So, the seller of the put keeps the premium he was given when he sold the put and makes a nice profit. Even better the seller of the put gets this premium when he sold the put and hence is free to invest this money somewhere else, let us say Treasuries and get an additional yield on it.
- If the price of the stock goes below the strike price, i.e., below $65 in this case, then the put has value. Let us say the price of BRK.B falls to $60 in February 2012. The lower it goes the worse off the seller of the put is. He might have to buy stocks at $65 a share when they are selling for $60 on the open market. For the long-term investor who bides his time for the correct price of the securities or an over-reaction by the market, this does not seem like a great deal. Might he not be better off not selling the put and buying the stock when it is substantially below the strike price? This is what we aim to discuss in this article.
There are positive and negative things with every strategy, even with puts. The question is whether the positives outweigh the negatives. Can we actually use it for our own good?
We will divide uses of writing puts in a two different sections, building a position in an overvalued market and earning income in a rang bound market.
Building a stock position
Let us suppose that you like a stock very much. But the stock is a tad over-valued. You would like to start a position in the stock at a lower price. What can you do? You can wait for the price to drop below what you consider a fair value for you, or you can write and sell a put option.
As an example, let us take the JNJ stock. JNJ is selling for $65 a share and has a P/E of 15. JNJ is a company with history of dividend increases and will likely survive several decades. It is also a very shareholder-friendly company and has among its admirers Warren Buffet, who owns 1.56% of the shares outstanding. There is only a small problem. You would be more comfortable if the price of the stock was somewhere around $59. What can you do?
Let us look at the current option market for JNJ for January 2012 expiration (the data is from Bloomberg Businessweek).
|Put JNJ 55||0.77|
|Put JNJ 57.5||1.06|
|Put JNJ 60||1.55|
|Put JNJ 62.5||2.29|
If we look at the table then ignore commission, we might consider selling a put option for JNJ expiring in January 2012 with a strike price of $60 (and get $1.55 premium now, making our average price $60-$1.55=$58.45) or a strike price of $57.5 (making our average $57.5-$1.06=$56.45). If JNJ goes below that price, we get an opportunity of getting the shares at a lower price than what we would have wanted to pay. If it does not go down then we get the premium for free. We then might decide to write and sell a new put.
The same strategy can be used in a market which is going nowhere and is range bound. When the market is range bound, a long-term investor can either buy more shares and wait for the market to go up or he can generate additional income by writing puts. He should make sure to only write puts in companies whose stock he does not mind owning (note that the long-term investor was willing to buy the stock at the current price).
If the investor thinks the market is overvalued, then he can also write puts at significant discounts to get some side income. Ideal companies for using these kinds of strategies are large-cap dividend aristocrats with shareholder-friendly approaches like MCD, JNJ, PG, KO.
Like any investment, writing puts carries risks. Investors take the risk of having to buy a stock that may be heading lower than the strike price. Value investors with a long time horizon can use this risk as an opportunity to build position at prices below the market price of the stock. But we need to consider the possibility that we might be wrong about the fundamental of the stock and risk losing money if the puts are exercised when the stock is trading lower in the open market.
There are two things a put seller can do in this case.
- Buy the put at a much higher price, if the fundamentals of the company have deteriorated and the put seller does not want to own the shares anymore.
- Buy the stocks of the company at a higher price, i.e., strike price - premium. This is advisable if the fundamentals of the stock have not changed.
But let us not forget that we sold the put because we thought that the stock was undervalued and owning it was a good idea. In fact, we wanted to own the stock at a much higher price. If we had bought the stock out-right we would have a higher buying price and hence larger loss. So it can be argued that writing puts is the only way to buy good cheap stocks. You get to keep the premium if the stock does not decline too much and otherwise you have a lower entry point than what you would have had if you had bought the stock outright.
Options are generally sold in a bundle of 100 stocks. What this means is that in the case of JNJ a $55 put expiring in January 2012 you will either buy or sell 100 puts costing $77. In this case one needs to consider the case when the put is exercised and the seller of the put has no money to cover his obligation. In this case, brokers like IB will loan you the money automatically and fill the order. For JNJ this will imply that the put seller will own 100 shares of JNJ and will have a negative $5500 in his account. If the account goes below the margin requirement, it might be liquidated. This is not a scenario we want to encounter.
To not let this scenario happen, always sell puts when you have cash to back it up. For a long-term value investor this is no problem as he wanted to buy the stock and had money to back up the transaction. The importance of this point cannot be highlighted enough.
We also need to discuss the fact that the $5500 in the above scenario is going to be sitting there as a collateral in our account till January 2012 and doing nothing. We get $77 to show for it, which is a measly 1.4% yield in four months. If we had bought the stock and it had gone up then we would have made much more (and additionally dividend for owning the stock, in case of JNJ). But as a long-term investor we must keep in mind the basic philosophy. Never ever buy at a price you are not comfortable with. Nobody knows the future and a good entry point is essential to turn a good bad investment into a great one. And this is the key point which will let you sleep well at night.
Instead of fearing and staying completely away from the derivative markets it seems that it is possible to use them in a good way. In fact, sometimes selling put options can be a much safer and better way of investing in your favorite stock. It may also help generating an income in a range-bound market. For serious long-term investors, selling puts might be worth looking into.