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In our first article, “Covered Calls: Mandatory Option Trading Techniques for the Income Investor,” we discussed the basic concepts of the covered call and how they might be used by an income investor to further one’s yield. This article is a follow up piece to address another popular type of option trade, which is the selling of puts. Much like the first article mentioned above, I will attempt to write this from the perspective of an income investor. Though selling puts is not directly related to the traditional definition of income investing, it is still a very useful tool that investors should be aware of.

Before diving right into the actual trades and ideas, one should take the time to review the basic premise of the put contract. The definition of a put is really a contract for the right to sell a specific amount of stock or equity, for a specific dollars amount, at a future date in time. (Special note, the put buyer can actually execute the contract before the expiration date is reached.) To have a put contract you need a buyer and a seller. Our article focuses on the selling of puts, but one needs to understand the opposite side of the trade as well.

Buying Puts

If one buys a put one is paying the seller a set amount of money so that the seller will be obligated to buy a specific number shares at a future date for a specific (strike) price. Consider the put buy as really nothing more than purchasing an insurance policy. If on the expiration date the price of the stock is above the strike price where the put it sold, then the put expires worthless and the seller gets to keep 100% of the funds the buyer paid and does not have to buy the stock. Examples are the best learning tool here so consider this situation using a real stock and corresponding prices:

We will use one of my favorite stocks, Dendreon as it has liquid options with high premiums. I will purchase 100 shares of Dendreon (DNDN) for $39.13 on 7/21/2011. That transaction cost me $3,913 + commissions. I like the stock but feel it might be in for a big fall for some reason. How do I protect my investment? I could buy a put. Look at the option chart below.

(Click charts to enlarge)



I’ll pick August 2011 for simplicity's sake. I decide I want to be able to sell my shares of DNDN for $38 a share, so I buy the $38 put. This will cost me $1.17 per contract and 1 contract is equal to 100 shares so all I need to buy is 1. To put my little insurance policy in place it will cost me $117 (100shrs x $1.17)+ commissions and it will run out on the third Friday of August. If by that time DNDN stock price appreciates to $60 a share then the put will be worthless and the person I bought it from is going to keep my $117. After expiration he or she will no longer be obligated to buy my shares (although I bet he or she would like to). On the other hand, if DNDN’s stock price just sank down to $20 a share at expiration then the put will be worth a great deal. The put’s protection kicks in at the $38 mark. At expiration the put should be worth $18 a contract or $1,800 ($38 strike - $20 share price) x 1 contract (100 shares). Once again, as the put owner I could have the put contract executed at any time prior to expiration and make the seller take my shares at $38, but for this example let's stick it out all the way to expiration. The actual shares of DNDN that I bought have taken a loss but the put insurance policy did its job. I have not made any money, but hedged my position and really minimized my losses. See below.



Without the put the total loss would have been $1,913 ($3,913 Original Cost - $2,000 Ending Value).

Selling Puts

Now that we have a working understanding of put buying, it is the time to get into the meat of the article on selling puts. Once again let’s make sure we all understand what it takes to be a put seller. When selling a put, one is agreeing to purchase a specific amount of a certain stock, for a specific price, within a given time frame. In return, as the seller one is going to be compensated for the promise by being paid cash upfront when the deal is made. In our example above with DNDN, let’s look at it from the seller’s point of view. As the put seller now, for some reason I've decided that it is a smart move to sell a put on DNDN at the $38 strike for August. As I initially enter the contract, my account is credited the $117 for selling one contract. Now remember, I'm on the line to buy those 100 shares at $38 at any point up to the expiration date, which will be the 3rd Friday of August. That being the case, most brokers will demand that I have ample cash reserves or margin in the account in case that happens. So here are the possible outcomes:

  1. August Expiration DNDN price $60 – If the ending price of DNDN is $60 on the option expiration date then the put I sold (also called shorted) is worth nothing. As the seller I will keep the $117 I was originally given and may do whatever I want with it. As the put expires, so do my broker’s reserve requirements for keeping a specific amount of cash or margin on hand as I'm released from the obligation to buy the stock. This outcome might be viewed as a positive or negative depending on my original motives for entering the trade. More to come on that later.
  2. August Expiration DNDN price $20 – If the ending price of DNDN is $20 on the option expiration date, then the put is really working against me. If I hold the short position all the way till assignment, then the end effect will be that I'll be the proud owner of 100 shares of DNDN, which cost $38 per share. Actually the cost per share will be a tad less as I'm still going to be able to keep the original $117, so the final cost per share will be $3,683 ($3,800-$117). This is definitely a losing trade as I got taken to the cleaners by the put buyer. The answer here was to exit the trade long before the price of the stock went to $20. The put seller can always buy his or her way out of the short position at any time. In this instance, it is hoped that the seller would have recognized the trade was going bad early on and would have just bought back the put for a much smaller loss than if it was held to expiration.
  3. August Expiration DNDN price $37.99 - If the ending price of DNDN is $37.99 on the option expiration date, then that is a winning trade. If one lets it expire then there is a very good chance that one will be put the 100 shares for $38 a share plus will still get to keep the $117 for the original transaction. That being the case, the total cost is actually $3,683 ($3,800-$117) or $36.83 per share. Another option here is that the put could be bought back for a few cents to close the position prior to expiration and a new put sold in the next month as the process is repeated.
  4. Early Assignment – In this case the put buyer executes the contract prior to expiration and forces me, the seller, to purchase the shares. I still get to keep the $117, but one only finds this situation when the stock price takes a nasty fall and the put is deep in the money. My cost will be the $3,683 for the 100 shares but odds are the stock is trading for much lower than that.

So the next question now is why would income investors want to sell puts. The answer to that actually depends upon how aggressive each income investor’s strategy is and how much risk each is willing to take. Typically one won’t find the average income investor trying to generate cash flow by selling put options and hoping the put expires worthless. That is just too risky for an income investor. What you will find though is that income investors will have wish lists of stocks or equities that they really want to own, but not at the current price. The concept is to sell puts at the strike price at which the investor would be willing to buy the shares. As an added bonus, the income investor would receive the cash premium from the put sell and be able to use it to further offset the costs of a purchase if they are indeed assigned the stock at expiration.

Now that we have a firm understanding of both buying and selling puts and the motives of why people use them, it is time to combine them to make a trade. Of the entire article this concept is actually the most important part, therefore it is imperative that every option trader, whether an income investor or not, understand the risks. As you continue down the road of put options you will find lots of people who will sell the naked puts to collect the maximum premium. Actually try to avoid this type of naked put selling as you are the one assuming 100% of the risk. For example consider the following chart for Arena Pharmaceuticals (ARNA). Although not an income investment vehicle, it has a perfect trading history to illustrate the concept.


ARNA is a a clinical-stage biopharmaceutical company, focuses on discovering, developing, and commercializing oral drugs in the therapeutic areas of cardiovascular, central nervous system, inflammatory, and metabolic diseases. Its clinical development programs include Lorcaserin that has completed Phase III clinical trials for the treatment of weight management. On September 9, 2010, the stock was priced as $7.21 a share and awaiting an FDA decision. While waiting for the decision, there must have been lots of puts changing hands on the market. Below is just an example and not based upon actual option trades at the time in question. If an investor had decided to sell the $7.50 November 2010 puts, my bet is that volatility was so high that there was lots of premium to be made. Let’s assume for every put sold, the seller got a whopping $2.00 per contract and our seller sold 10 of them. He or she received $2,000 ($2.00 x 10 put contracts) less commissions and were probably feeling pretty good about the situation. But then disaster struck as the FDA decision did not go according to plan and the stock price fell apart. Our poor seller is now on the hook to buy 1,000 shares of ARNA for $7.50 or $7,500 while the going stock price is now at $1.27 a share. Our investor has a loss of $4,230 ($7,500 purchase price - $1,270 current stock price -$2,000 premium received). If the investor would have combined the put sell with a purchase of a put at a lower strike to make a spread then the losses could be contained and the trade hedged. Let’s keep the same transactions but throw in a purchase of a $5 put for $1.00 to make a spread and add protection. Here is what would have happened with that put spread in place at expiration.

Arena Final Stock Price $1.27

Short 10 $7.50 puts ($7,500)

Long 10 $5 puts $5,000

Total Loss Exposure ($2,500)

Less Premium Received $1,000

Total Loss ($1,500)

We still lose on the trade as a whole but I would rather lose the $1,500 compared with $4,230 without the put. This is just an illustration and not based upon exact option trades but it gives a wonderful, eye opening example of why you should not sell naked puts but should almost always combine them with the long puts at lower strikes. It will eat into the cash you receive for the put sales but better to be safe than sorry.

Ok, that is enough on the basics of selling puts. Now let’s get into some ideas for income investors to sell put spreads to generate cash and acquire equities at lower costs per share.

Penn West (PWE): Penn West is a well known Canadian income investment. PWE engages in acquiring, exploring, developing, exploiting, and holding interests in petroleum and natural gas properties in North America. The land mass from which Penn West operates totals 6.2 million acres. The company drilled 185 net wells in the first quarter of 2011 compared with 65 net wells in the same period of 2010. Gross revenue for the first quarter was C$844 million, which was an increase when compared with first quarter 2010’s figure of C$806 million. Penn West pays out a quarterly dividend that is currently a 4.9% yield. This is the kind of company that income investor will be attracted to. A look at the chart shows there seems to be some support at the $22 mark as the stock has bounced off that area twice since June 2011.

After careful consideration let's say we decide we would be a buyer of the shares at that price of $22. We look at the option chain and decide to sell the 10 December $22 puts for $1.35 a contract or $1,350 ($1.35 x 10 contracts = 1,000 shares). For our protection from some unknown black swan event, we will use some of the proceeds to buy protection in the form of 10 December $19 puts for $0.50 a contract or $500 ($0.50 x 10 contracts = 1,000 shares). Our total amount received is $850 ($1,350 - $500). Our risk factor is $2,150. This is calculated by taking the put you are short ($22) and subtract the put you are long ($19) and multiply by the number of shares involved (10 contracts = 1,000 shares). That number is $3,000 and then one must subtract the $850 initially received and you get your risk factor. This is your maximum risk in case the worst happens.

Now we wait until the third Friday of December 2011 to see what happens. As long as we stay above $22 per share, the put option we sold will slowly start to erode in price until it expires worthless. If we are put the shares we will be getting them for $21.15 (1,000 shares at $22 less $850 premium received), which was our intent in the first place. Finally remember we can get out of this trade at any point by buying our way out. If PWE were to start into a downtrend and showed signs of weakness, we can always pull the plug and get out early and formulate the next plan based upon the news and events at hand.

American Capital Agency Corp. (AGNC): AGNC is a favorite of income investors. AGNC is a real estate investment trust. It invests in agency pass-through securities and collateralized mortgage obligations for which the principal and interest payments are guaranteed by a U.S. Government agency or a U.S. Government sponsored entities. The company funds its investments primarily through short-term borrowings structured as repurchase agreements. The company pays a quarterly distribution, which is currently yielding a 19.1% return. In late June of 2011, AGNC announced a secondary offering, which involved the sale of 43,200,000 shares of common stock for gross proceeds of roughly $1.2 billion. Looking at the chart we seem to have a support line at $28 and after careful consideration let's say we decide we would be a buyer of the shares at that price. We look at the option chain and decide to sell the 10 December $28 puts for $1.20 a contract or $1,200 ($1.20 x 10 contracts = 1,000 shares). For our protection from some unknown black swan event, we will use some of the proceeds to buy protection in the form of 10 December $25 puts for $0.40 a contract or $400 ($0.40 x 10 contracts = 1,000 shares). Our total amount received is $800 ($1,200 - $400). Our risk factor is $2,200. This is calculated by taking the put you are short ($28) and subtract the put you are long ($25) and multiply by the number of shares involved (10 contracts = 1,000 shares). That number is $3,000 and then one must subtract the $800 initially received and you get your risk factor. This is your maximum risk in case the worst happens.

Now we wait until the third Friday of December 2011 to see what happens. As long as we stay above $28 per share, the put option we sold will slowly start to erode in price until it expires worthless. If we are put the shares we will be getting them for $27.20 (1,000 shares at $28 less $800 premium received) which was our intent in the first place. Finally remember we can get out of this trade at any point by buying our way out. If AGNC were to start into a downtrend and showed signs of weakness, we can always pull the plug and get out early and formulate the next plan based upon the news and events at hand.




Apollo (AINV) is a great example of a Business Development Corp and is also a favorite for income investors. As of 3/31/2011, the company has 69 holdings, representing $3.1 billion. The company invests in middle market companies and provides direct equity capital, senior secured loans and subordinated debt and loans. It will also invest in PIPES transactions. The company may also invest in public companies that are thinly traded, and may acquire investments in the secondary market. AINV prefers to invest in warrants, makes equity co-investments and may also invest in cash equivalents, U.S. government securities, high-quality debt investments that mature in one year or less, high-yield bonds, distressed debt, non-U.S. investments or securities of public companies that are not thinly traded. The company typically invests in building materials, business services, cable television, chemicals, consumer products, direct marketing, distribution, energy and utilities, financial services, healthcare, manufacturing, media, publishing, retail and transportation. It primarily invests between $20 million and $250 million in its portfolio companies. The company seeks to make investments with stated maturities of five to ten years. The current yield is 11.4% and is paid quarterly. Looking at the chart we seem to have a downward trend but found support at $9. After careful consideration let's say we decide we would be a buyer of the shares at that price. We look at the option chain and decide to sell the 10 December $9 puts for $0.50 a contract or $500 ($0.50 x 10 contracts = 1,000 shares). For our protection from some unknown black swan event, we will use some of the proceeds to buy protection in the form of 10 December $7 puts for $0.15 a contract or $150 ($0.15 x 10 contracts = 1,000 shares). Our total amount received is $350 ($500 - $150). Our risk factor is $1,650. This is calculated by taking the put you are short ($9) and subtract the put you are long ($7) and multiply by the number of shares involved (10 contracts = 1,000 shares). That number is $2,000 and then one must subtract the $350 initially received and you get your risk factor. This is your maximum risk in case the worst happens.

Now we wait until the third Friday of December 2011 to see what happens. As long as we stay above $9 per share, the put option we sold will slowly start to erode in price until it expires worthless. If we are put the shares we will be getting them for $8.65 (1,000 shares at $9 less $350 premium received) which was our intent in the first place. Finally remember we can get out of this trade at any point by buying our way out. If AINV were to start into a downtrend and showed signs of weakness, we can always pull the plug and get out early and formulate the next plan based upon the news and events at hand.




Navios Maritime (NMM): NMM owns and operates dry cargo vessels on an international basis. The company is known for hauling such drybulk items as iron ore, coal, grains, and fertilizers. Their fleet consists of 10 Panamax vessels, 5 Capesize vessels, and 1 Ultra-Handymax vessel. NMM’s tries to charter out under long-term time frames. Currently the average remaining term of their charter is approximately 4.3 years to a strong group business partners, which provide a stable base of revenue and distributable cash flow. Navios Partners has currently contracted out 100.0% for 2011, 95.2% for 2012 and 75.1% for 2013, generating revenue of approximately $176.8 million, $170.7 million and $133.9 million, respectively. The average contractual daily charter-out rate for the fleet is $30,270, $30,601 and $32,560 for 2011, 2012 and 2013, respectively. The average daily charter-in rate for the active long-term charter-in vessels for 2011 is $13,513. The current yield is 9.9%. Looking at the chart we seem to have a support line at $17 after a recent decline in price. After careful consideration let's say we decide we would be a buyer of the shares at that $15. We look at the option chain and decide to sell the 10 December $15 puts for $0.60 a contract or $600 ($0.60 x 10 contracts = 1,000 shares). For our protection from some unknown black swan event, we will use some of the proceeds to buy protection in the form of 10 December $12.50 puts for $0.15 a contract or $150 ($0.15 x 10 contracts = 1,000 shares). Our total amount received is $450 ($600 - $150). Our risk factor is $2,050. This is calculated by taking the put you are short ($15) and subtract the put you are long ($12.50) and multiply by the number of shares involved (10 contracts = 1,000 shares). That number is $2,500 and then one must subtract the $450 initially received and you get your risk factor. This is your maximum risk in case the worst happens.

Now we wait until the third Friday of December 2011 to see what happens. As long as we stay above $15 per share, the put option we sold will slowly start to erode in price until it expires worthless. If we are put the shares we will be getting them for $14.55 (1,000 shares at $15 less $450 premium received), which was our intent in the first place. Finally remember we can get out of this trade at any point by buying our way out. If NMM were to start into a downtrend and showed signs of weakness, we can always pull the plug and get out early and formulate the next plan based upon the news and events at hand.




Hatteras Financial Corp (HTS): HTS operates as an externally-managed mortgage real estate investment trust [REIT]. It invests in single-family residential mortgage pass-through securities guaranteed by a U.S. Government agency or issued by a U.S. Government-sponsored entity. Like AGNC, Hatteras Financial Corp started in 2008 and has thrived in the current low interest rate environment. The REIT declared a quarterly dividend of $1.00 per common share for the second quarter of 2011 which places the yield at close to 13.9%. Looking at the chart we seem to have a support line at $28 to $27.50. After careful consideration let's say we decide we would be a buyer of the shares at that price at $27. We look at the option chain and decide to sell the 10 November $27 puts for $0.75 a contract or $750 ($0.75 x 10 contracts = 1,000 shares). For our protection from some unknown black swan event, we will use some of the proceeds to buy protection in the form of 10 November $24 puts for $0.20 a contract or $200 ($0.20 x 10 contracts = 1,000 shares). Our total amount received is $550 ($750 - $200). Our risk factor is $2,450. This is calculated by taking the put you are short ($27) and subtract the put you are long ($24) and multiply by the number of shares involved (10 contracts = 1,000 shares). That number is $3,000 and then one must subtract the $550 initially received and you get your risk factor. This is your maximum risk in case the worst happens.

Now we wait until the third Friday of November 2011 to see what happens. As long as we stay above $27 per share, the put option we sold will slowly start to erode in price until it expires worthless. If we are put the shares we will be getting them for $26.45 (1,000 shares at $27 less $550 premium received), which was our intent in the first place. Finally remember we can get out of this trade at any point by buying our way out. If HTS were to start into a downtrend and showed signs of weakness, we can always pull the plug and get out early and formulate the next plan based upon the news and events at hand.



Conclusion

In conclusion, this article's major goal was to introduce the income investor to the basics of selling puts. The act of selling the puts is not really in itself what would be considered income investing, but it is not hard to see how it can fit into one's portfolio under the right circumstances. Most income investors will use this technique to try to scale into certain stocks and equities at lower prices. Needless to say, there are risks involved, which were presented above. Finally the examples above were meant to show how selling the puts might be used in a real life situation. In each example there was always a component of "careful consideration" that came into play that made the investor want to enter the trade. That is one of the most important aspects as one needs to take a lot into account before trading puts. This would include such items as current price trending, price support levels, estimated dates of upcoming dividends and distributions, specific company news, and external factors that might have a material impact upon the sector as a whole. Basically one better have a good understanding of the stocks one is selling puts on. That being said, welcome to the wonderful world of puts.

Disclosure: I am long PWE, DNDN.

Source: Selling Puts: Mandatory Option Trading Techniques for the Income Investor