"Selling puts is like picking up nickels in front of a bulldozer." So runs the old Wall Street aphorism. However, many investors regard the sale of puts as a conservative, income generating strategy. To them, selling a put is like getting paid to issue a limit order. This article discusses the nature of the risks involved, then goes on to present some thoughts on quantifying them. Please bear in mind that I'm an individual investor talking shop, not a guru giving advice.
I regard the sale of puts as a useful and profitable tool in reflecting my opinion on certain stock situations, and believe that many strategies involving the sale of puts have excellent risk/reward characteristics. However, it's important to understand how puts can behave in practice before selling them.
Risks Arise from Several Sources
There's a distinction between the normal investment risk associated with stock ownership, and risk created by the use and/or mismanagement of margin, leverage or thinly traded derivatives. There's also a distinction between risk from an individual company's financial performance and risk from the action of the market as a whole. Excessive exposure created by selling naked puts can create problems in the event of a serious market crisis.
These risks arise from the maintenance requirements of a margin account, due to the exposure to margin calls during market crises. Here's a snip from a Margin Handbook (click to enlarge images):
While initial maintenance requirements may be low, if the position moves against the investor they will be increased, creating the potential for margin calls. Note that the brokerage always has a buffer over the market value of the puts, equal to either 20% of the share price or 10% of the exercise value.
A stock may be placed in a special maintenance or margin category, which will result in the sudden imposition of a 100% cash secured requirement on naked puts. During the financial crisis I had a number of stocks where this happened, and experienced inconvenience and concern in dealing with the situation.
Here's where it gets problematical. What if there is no market for the options involved? As an illustration, here's a snip of a Unitrin (UTR) options position from my account:
This went on for weeks. The trade was profitable, and was ultimately closed at expiration for a stunning profit on a relatively short hold. But nobody was making a market for the options, and the market values and more importantly the maintenance requirement stayed out of line until expiration. The account had ample cash and marginable securities, so the bogus maintenance requirement was not a problem.
But a similar situation, which is more likely to occur at market bottoms, could cause unnecessary financial pressure and loss, due to the conduct of the market maker, not making a market, and the brokerage, applying rules on margin.
Your friendly broker is a hazard during times of market stress. Consequently, in addition to the normal risks associated with stock ownership, the sale of naked puts adds financial/leverage risk, and then an unquantifiable dash of exposure to the conduct of others. The market maker will leave the building: The liquidity providers will stash their cash on the sidelines.
Computing Returns on the Sale of Puts
In computing the return on the sale of a naked put, it's a good idea to consider the amount of cash used to back it up, since the apparent return and risk will vary accordingly. Here's an example, presenting the sale of puts on Hartford Financial (HIG), in two versions. One is fully cash secured; for the other, the investor sets aside his broker's maintenance requirement. The are also two outcomes: in one, the stock is unchanged at expiration; in the other, it tanks from 26.93 to 15.00.
Note that XIRR (the spreadsheet function that calculates internal rate of return for an irregular stream of payments) varies depending on the amount of cash security assumed. A bad outcome on a put where the investor cannot meet his broker's maintenance requirements will generate margin calls - creating pressure to sell assets under duress at market bottoms.
Caution is in Order
Investors who sell puts need to consider the above facts and govern their actions accordingly. During periods of extreme market stress, correlations go to 1 and all stocks decline in unison. Puts are not risky when used with due caution: the risk arises from the careless sale of naked puts in excess of the resources available to support the obligation.
Selling a moderate amount of puts from an account that doesn't otherwise make use of margin or other forms of leverage wouldn't be cause for concern about margin calls. In a case like that, the investor can sell some puts on stocks he would like to buy anyway and enjoy either a little extra income, or bargain prices on selected stocks.
Selling a Put Equivalent to a Covered Call
Certain sophisticates on Wall Street disparage the covered call strategy, along the lines of "big deal, you sold a put." In point of fact the risk profiles of a covered call and a cash secured put are identical. The sale of covered calls is widely regarded as a low risk strategy.
The cash secured item is important. If the sale of a put is not cash secured or supported by a short position, it's a leveraged strategy and the risk needs to be evaluated in that light.
Quantifying the Risk
It is possible, using beta relationships and applying the math from a margin handbook, to develop hypothetical maintenance or margin requirements for a given percentage decrease in an index. The S&P 500 would be the most common yardstick.
The reasoning would be along these lines: If the S&P goes down 15% and a stock has a beta of 2.5, the stock would go down 37.5%. Having developed a theoretical minimum share price, the maximum probable maintenance requirement can be computed.
By this line of thinking, if the S&P goes down 40%, a stock with a beta of 2.5 goes down 100%, resulting in a demand for full cash security. As mentioned earlier in the article, it can actually work that way at times.
Margin of Security
Another way of thinking about risk involves margin of security. In attempting to estimate the minimum value of a stock, factors such as tangible book value, historical minimum P/S, P/E, or P/B can be considered. With March 2009 still fairly close, I sometimes use stock prices or valuation ratios from that period as a minimum.
For example, Procter & Gamble (PG) traded at a minimum Price/5 year average EPS of 14.1 during the crisis. Projecting 5 year average EPS at 3.67, I multiply by 14.1 and see 51.74 as a minimum probable price point. I have an Excel workbook that I complete for most positions, and it computes a probable minimum on this basis, a figure I can look at when considering the sale of puts.
I think margin of security type thinking is the best way to control risk when selling puts. As a value investor I frequently have an opinion on minimum values and can limit the sale of puts to situations where I regard the go to zero risk as remote.
Briefly, the sale of naked puts is a leveraged strategy, conducted from within a margin account, and subjects the seller to special risks involving the interaction of margin requirements and the conduct of brokers and liquidity providers at market extremes, as well as the normal investment risk associated with the underlying.
While this article highlights the risks inherent in the sale of naked puts, I believe that there are situations where the risk is well worth dealing with, and strategies involving the use of puts that are viable and productive on a risk/reward basis. That will be the topic of future articles.