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Options II: Strategy for the Long-Term Investors - Writing Puts

October 14, 2011 | About:
Chandan Dubey

Chandan Dubey

97 followers
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 (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).

PutLast price
Put JNJ 550.77
Put JNJ 57.51.06
Put JNJ 601.55
Put JNJ 62.52.29


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.

Earning income

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.

Risks

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.

Margins

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.

Bottom-line

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.

About the author:

Chandan Dubey
I invest because I want to be free by the time I reach 40 years of age i.e., 2025. My investment style is to find a small number of bets with large margins of safety. I pay a lot of attention to management and their incentive. Ideally, I like to buy owner operator businesses. I am fortunate to have a strong inclination towards studying. I aid my financial understanding by extensive reading in psychology, economic, social sciences etc.

Rating: 4.1/5 (16 votes)

Comments

Adib Motiwala
Adib Motiwala - 2 years ago
cdubey,

Good series of posts. Keep up the good work. I had posted two articles on similar topic of Covered Calls and Cash Covered Puts last year.

I agree pretty much with everything you wrote in this article. I am a regular seller of puts and calls. However, I wanted to bring up a few points from your article

1) "If it does not go down then we get the premium for free" - in the building a position...

There is no FREE lunch in this world. The reason Put writers get a premium is because we are selling insurance to the buyer. It is true that most times puts would expire worthless. However, when the underlying stock crashes, it is likely that you will be put the stock at a much higher price than the market price. In short, the premium is NOT FREE. You put capital at risk to earn it.

2) Risks: You did not mention one of the biggest risks in selling puts. Its not only that you may catch a falling knife. The biggest risk is that you may never buy the stock as the stock has a huge run up (while you wait for it to fall and purchase it via the put. ).

Last year, this happened to me a lot. Example: I sold a put on Fossil at $35 and the stock ran up to $100+. So all i earned was a measly 2% premium while the stock was up 3 fold.

So, how do you over come this risk?? It depends on the stock, how you feel about it, how its valued and how you will feel if it runs away. If you have done your work on the company, like it, valuation seems reasonably good to start a position, then you can build a starter position at the least. You can augment this by selling puts at lower strike prices so you can add to your position. This way, if there is a huge run up in the stock, you own some shares. If the stock falls, you can possibly buy more via the puts or in the market.

Keep up the good work. Look forward to your other articles.

Adib Motiwala

rcgroups1
Rcgroups1 - 2 years ago
Good article, keep it coming

Adib you have good point too.

What I learned is long term value stocks (some call them boring stocks but I like them a LOT) usually don't move much faster. And make sense to sell put options to earn more returns. (jnj, pep, ko, kmb,Brk etc..)

Fast moving stocks which have more volatility and are risky I would rather buy outright and buy puts to cover the risk. Which helps me get all upside like Fossil.

cdubey
Cdubey premium member - 2 years ago
@Adib: Thank you for the suggestion. I was considering writing about it, but then decided against it because I wanted it to keep it simple and also useful for value investors. Your comment will be excellent for people who understand options more and will help them explore this tool on their own.

I am going to write more in the coming weeks, hopefully. Still learning and it is always good to have a discussion going.

As a general note, the idea was to write puts for really good stock which you believe is a bit over-valued. You missed out on Fossil (by writing puts) because you were not sure about its prospects. On a fundamental basis you thought it was maybe a bit overvalued. So, in a sense writing put turned out to be a good deal for you (and very smart, if i may say so). If you had bought the shares and they went down, you would have been worse off. Your idea of doing a bit of both (writing puts and buying some stock) is also one to note. Will definitely add it in my tool-kit. Thanks for that.

If one thinks that the stock is undervalued then one is better off buying the stock outright.
waup7707
Waup7707 - 2 years ago
Very good general put writing approaches.

I have been writing many puts and few calls in years, and the results are very satisfactory.

Some points I would like to bring up,

1. Opportunity cost

Covered put writing (cash set aside to buy underlying securities) doesn’t involve leverage. But you may tie up valuable dry power. There are several conservative ways to mitigate this,

+ Reserve cash based on “put-back” probability: For example, you write puts for two stocks and each one has 25% chance get assigned. By adding margin of safety, you may need to set aside 50% (2x) cash instead of 100% (4x). Remember probability involves unpredictability and you want to err on conservative side.

+ Sell out-of-money puts: The deeper a put is out-of-money, the less likely it gets assigned. Of course, you collect fewer premiums.

+ Sell puts with expiration dates spreading out: Using LEAP, you can spread put contracts over several years and that gives you ample time to come up with cash if a put becomes more likely to be assigned. Today, you can sell put as far out as January 2004.

2. Volatility

Volatility is one key variable in determining the premiums of option contracts. As an option seller, you need to think like an intelligent insurance underwriter. You want to be an aggressive put writer only when the market is hard which means panic is in the air and people are scrambling to pay large premiums for down-side protections. I made most money on puts when there was blood in the streets (Q4 2008 and Q1 2009), oil in the waters (June 2010 BP blowup).

3. Tax Efficiency

Gains on options are treated as short term even you hold the investments for more than one year. However, you collect premiums first and don’t report the gains until they are realized. You can keep the money for years (think insurance floats) before paying taxes on gains. I haven’t pay taxes on the premiums I collected in Q4 2008 from selling puts expiring January 2011. All those puts had expired out-of-money and I am free to use the funds for over 3 years before taxes are due in April 2012.

To be a good option investor, you need to be a good business analyst first. You need to know the intrinsic value of a stock to determine the attractiveness of its option. Then, writing options can be used to reduce risks (lowering buying cost) and/or enhance returns (collecting premiums which are likely to be free money with contracts expiring out-of-money).

cm1750
Cm1750 premium member - 2 years ago
Another related approach is a risk reversal strategy when the market drops as it did a few weeks ago.

For example, if a blue chip stock is $50 and you think downside is very limited but the upside is only moderate (10-15%), you can buy a Jan 2013 50/55 LEAP call spread and partly fund it with Jan 2013 40 puts.

As long as you are level 3 options approved, you don't need cash although I recommend a cash cushion equal to 25% of the nominal put value.

As Waup7707 mentioned, if you don't know the range of likely valuations (99% confidence interval), selling options can get you killed - just ask anyone who sold a $80 Bear Stearns put when it was $100 or a C 40 put when it was $50.

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