Sometimes, we sell PUTs on stocks that we would like to own, but wish to own at a significant discount from the current price. That's where short PUTs can be useful. They pay you to wait for a lower price, which you promise to pay someone who bought the PUT as a form of insurance to limit their downside.
Obviously traders are in there too, but the PUT concept is to provide downside protection to those with long positions in a stock.
If you would be inclined to purchase the stock at the PUT strike price, then selling a PUT at that strike is about the same level of risk as using a good 'til canceled limit order at that strike.
The credit from a short PUT is larger when general market volatility is elevated, when the individual stock is in a downtrend, or when the individual stock suffers a sudden price shock. Those are the best times for shorting a PUT.
YUM! Brands (YUM) just experienced a big price shock, yet we believe that its long-term prospects are very good.
Being interested in YUM for its long-term thematic attributes as a fast food company with a large and growing China footprint, but feeling that it has been too expensive; we were attracted by the sudden price move down.
After looking at it a bit further, we sold January 2013 PUTs with a $60 strike price. That is 10.55% below the Friday close, and 19.73% below the 52-week high, and just about at the lower edge of the 90% price probability range using the 1-year historical volatility; and according to the implied volatility of the options, about a 13% chance of the price going below $60 by the expiration.
If the price goes below $60, we will end up owning YUM, as we would if we used a GTC limit order at that price; but if the price does not take another 10% down leg from the approximate 10% decline Friday, we will earn an annualized 5+% on the capital exposed to assignment, which is also over 50% annualized on the option requirements (collateral) to hold the position.
We are paid to provide comfort to someone else to agree to do something for them that we probably would do for ourselves anyway if we weren't being paid. Not a bad deal really if you look at it that way.
If we are assigned, that's OK at that price. If we are not assigned, we earn an attractive yield on our cash or margin capacity. If the stock takes off in the upward direction, and if we were willing to pay the price, we can still buy it, and the PUTs would fall in price (gain for us) which we could ride to expiration or buy-to-close to free up our cash or margin capacity.
The tables that follows lay out a lot of the numerical side of the reasoning behind the position.
NOTE: We are not disclosing our position size in the table. The 10 contract size in the table is an illustration of the data. We chose 10 contracts for the illustration, because that is the size after which the cost of commission is generally proportional to the number of contracts. Below 10 contracts, the commission minimums tend to be disproportional to the size of the trade.
The upper left table runs through basic metrics for the PUT. The lower left table shows how yield and valuation at the strike price compares to the levels at the current market price. The table on the right, provides some analyst rating information, technical info, and measures the percentage move from the strike price to some analyst target prices.
Disclosure: QVM has positions in the YUM Jan13 60 PUT as of the creation date of this article (December 3, 2012). We certify that except as cited herein, this is our work product. We received no compensation or other inducement from any party to produce this article, and are not compensated by Seeking Alpha in any way relating to this article.
General Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions. This article is presented subject to our full disclaimer found on the QVM site available here.