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Here in Part 3 of a series on options strategies, we're going to examine a simple way to generate additional income while making long investments in publicly traded stocks. Put options - contracts that give the buyer the right (but not the obligation) to sell a stock at a predetermined price on or before the expiration date - will be the weapon of choice. In a nutshell, the strategy consists of selling naked, at- or near-the-money put options on stocks with wide "economic moats" that we would like to or are planning to purchase outright anyway.

In this strategy, we are generating additional income (in terms of the option premium) by selling a put option that may force us to buy stock (which we were already going to buy) at the predetermined strike price of our choice. If I was going to buy 100 shares of Apple today at $390, the logic goes, why wouldn't I simply sell an AAPL December 17 2011 $390 put option for $13.35 per share? If the stock goes up, and come December 17 Apple is trading above $390, I just made $1,335 from the premium, as the put option would expire worthless.

Even if the stock goes down, we have a lower break-even price from selling the put than had we simply bought the stock outright: If the AAPL goes down to $370, I only lost $665 ($2,000 loss on the stock less the $1,335 option premium). Conversely, had I simply bought 100 shares of AAPL at $390, I would have instead lost $2,000 if AAPL went to $370.

Compared to simply buying stock outright, the only real downside to this strategy is that we have a maximum gain, equal to the put option's premium. However in this example, even with the short option expiration, if the stock ends up above $390 on December 17, the $1,335 we receive from the put premium represents a 3.5% return on capital in just over one month.

Before moving on, let's explain a few basics. A "naked" put option is a put option sold without a short position to cover it. If you sell a "covered" put option, for example, that means you are already short 100 shares of the underlying stock so that, in the event that the put option is exercised, you are forced to buy the 100 shares, thus cancelling out your short position. In this strategy, we will be writing naked put options.

"Economic moat," a term coined by the Oracle of Omaha himself, refers to the extent to which a company possesses "characteristics that act as barriers against other companies wanting to enter the same industry" - examples include having a strong brand name, pricing power and a large portion of market demand. Some securities analysis firms, such as Morningstar, actually assess publicly traded companies' economic moats in their reports.

However, just because it is generally accepted that a company does have a wide economic moat, that doesn't mean the company's stock won't fall. Rather, as selling puts exposes us to downside price risk, choosing companies with wide economic moats for this strategy is more of a safety precaution, as such companies benefit from existing competitive advantages and are generally less likely to trade drastically below fair value than are companies with no economic moat. Although this is an important criteria on which to evaluate stocks for this strategy, we should also be looking at companies' valuations (fair value estimates, P/E ratios, etc.) and growth prospects when selecting companies that we would want to buy at current prices.

Also, as with most basic options strategies, this strategy works best with stocks that have significant liquidity and volume in the market for their options. If a stock's options are thinly traded, it can be difficult to get good prices when entering and exiting positions.

Now that we've outlined the basic strategy, let's examine how it works. First, we must choose a stock with a wide economic moat that we would want to buy at the current price. I can think of a few stocks that, in my opinion, currently meet this criteria:

Attractive Wide-Moat Stocks

Price

Price/ Earnings Price/Cash Flow Price/ Book Debt/

Equity

3 Year Revenue Growth
Abbott Laboratories (NYSE:ABT) $54.50 18.8 8.7 3.5 0.2 10.7%
Applied Materials (NASDAQ:AMAT) $12.64 8.7 7.6 2.0 0.2 -0.6%
BNY Mellon (NYSE:BK) $20.39 9.4 52.2 0.7 0.1 7.0%
Exxon Mobil (NYSE:XOM) $79.09 9.5 6.8 2.4 0.2 -1.8%
General Electric (NYSE:GE) $16.20 13.3 5.1 1.4 2.2 -4.5%
Novartis AG (NYSE:NVS) $55.16 12.9 9.2 2.0 0.2 10.6%

As you can see, most of these companies have little debt and trade below 15x earnings; all have market caps above $10 billion. Aside from XOM and to some extent BK, however, most of these companies are currently less attractive from a technical standpoint. Let's use Exxon Mobil (XOM) for our example.

Now that we've selected the stock we want to use for the strategy, we must now decide upon our investment horizon for this strategy by choosing the put option expiration. This decision should be made based upon how long you intend to hold the position. If XOM is a stock you'd like to hold for a long time, then sell an option with a further expiration, and receive a higher premium. Conversely, if XOM is a company that you are bullish on in the near term, but uncertain about in the longer term, choose a shorter expiration. For reference, here are the values of same-strike XOM put options with different expirations:

XOM $80 Strike Put Option Value

Expiration Premium
Dec 17, 2011 $2.69
Jan 21, 2012 $3.65
Apr 21, 2012 $5.75
Jan 19, 2013 $10.45

Last but not least, we must choose the strike price of our put. Staying near-the-money is usually the best way to proceed. One good way to compare the potential return on capital of different-strike options is to divide the option premium by the strike price; in percentage terms, this represents your maximum return on required capital (without use of margin). The capital required in order to write one $80 strike put option without margin, for example, is $8,000, reflecting the price of the stock you would be forced to buy if the put option you sold was exercised.

The goal is to have the put premium represent at least 2% of the capital required for the trade, as that reflects the maximum return possible from the strategy. By this measure, far out-of-the-money put options are usually too cheap to make the strategy worthwhile. Conversely, selling higher-strike put options raises your break even point and increasing downside risk, but may be appropriate for the strategy if you are super bullish on the stock, and anticipate the it to rise significantly above its current price. If I thought XOM was going to hit $100 by January 2012, it wouldn't be unreasonable to sell the January 2012 $85 put options.

Moving on to our example, let's look at how this strategy would work using the April 21, 2012 $80-strike XOM option with a $5.75 premium. For comparison, we will examine the profit/loss from both our strategy (at expiration) and the profit/loss that would result from buying the stock outright, using XOM's current price of $79.09 as the cost basis for the latter:

Wide-Moat Put-Writing Vs. Long-Only Stock Purchase

Put-Write P/L XOM Price at Expiration Long-Only P/L
($925) 65 ($1,409)
($425) 70 ($909)
$75 75 ($409)
$575 80 $91
$575 85 $591
$575 90 $1,091

As you can see, if we sell the April 2012 $80-strike XOM put option for our strategy, and XOM ends up at or above $80 come expiration, we make $575, representing a 7.19% return. If we had made a long-only purchase of 100 shares of XOM, we would make only $91 if the stock went up to 80. In fact, the only scenario in which the long-only XOM investment returns greater than the XOM put-write strategy is if XOM ends up above $84.86 at expiration. Even though our maximum return on this put-write strategy is 7.19%, that is a significant return to see during a period of time shorter than 5 months.

Also interesting is the difference between the break-even point on the put writing strategy vs. that of the long-only purchase; if we sold the $80 strike April 2012 XOM put, we would break even so long as XOM ended up at or above $74.25. If we had simply bought 100 shares outright at the current price of $79.09, our break-even price is substantially higher.

In conclusion, wide-moat put writing is an excellent way to generate extra income while making bullish investments. If you are prepared to purchase a given stock such as XOM today, why wouldn't you simply write a short- to intermediate-term, at-the-money put option on the stock? The risk of loss involved in writing one put option is very similar to the risk of loss involved in buying 100 shares of the same stock outright.

Furthermore, because of the option premium, the break-even point for this strategy is generally substantially lower - and thus more favorable - than the break even point of the traditional long-only stock purchase. Although returns are capped at the value of the put option premium, this strategy can still yield double-digit annual returns - even if the underlying stock doesn't move.

Technical Notes

One of the risks involved with this strategy is the risk that the short put option will be exercised before expiration. Although this occurrence means that the option seller collects the premium, it also forces the put seller to purchase 100 shares of the underlying stock at the strike price, thus launching the put seller into a new, strictly-long position. If you are engaging in this strategy, and your short put option is exercised, you can simply sell the stock immediately; from here, it is quite simple to re-enter into the strategy by selling another put.

Alternatively, you could write a covered-call against the stock, maintaining a bullish position on the stock while implementing a strategy with a maximum gain and lower break-even point. It is also possible that short put option contracts may not be exercised; in the event that this happens, and the stock price winds up below the strike price at expiration, it may be necessary to buy back the put option before expiration depending on your brokerage's rules and restrictions.

Also, in order to sell one naked put without using margin, we must have enough money to buy 100 shares of the stock at the strike price. If we sell an AAPL December 2011 put with a strike of $400 in a non-margin account, for example, we had better have at least $40,000 available in the same account in case the put is exercised and we are forced to buy the 100 shares. If you are using margin/leverage, your brokerage would probably let you sell 2-3 $400 strike options in the same scenario with $40,000, but if the stock goes down, your brokerage may close your positions and force you to buy back the put options (so you don't collect the premium) if you violate margin requirements.

Source: Wide-Moat Put Writing: An Income Investing Alternative