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According to conventional option wisdom, selling puts offers an opportunity to "buy stocks at a discount'".

Let's say you're eying a stock that is priced above your target entry point. You can of course place a limit order, but if the stock stays above your limit price, you'll end up empty-handed.

Here's where put-selling advocates offer a better way: Instead of a limit order, sell a put at your limit price. If the put expires out of the money, you'll pocket the premium and can try again next month. If the shares are assigned, you'll pay the strike price, but because of the income from the short put you've actually acquired the shares at a discount. You can't lose!

This pitch is dangerously misleading.

The put will not be exercised if the share price descends only to the strike price. In fact, the put will likely be exercised only if the shares fall to the put buyer's break-even price, below the strike price.

Here's an example:

(For the sake of simplicity, the example calculations exclude brokerage charges. I've also assumed that the put buyer referenced in the example purchased the put speculatively rather than protectively, i.e. did not own the shares prior to purchasing the put.)

Assume that XOP is priced at $52.84, and you sell a December 2011 $48 XOP put for $1.40.

Now put yourself in the shoes of the put buyer on the other end of that trade. The put buyer's break-even point is $46.60 (strike price minus option premium paid). That is, the put buyer makes their money back if XOP falls to $46.60, they purchase the shares at $46.60, and assign the shares to you at $48. The put buyer starts making money as the shares drop below $46.60.

If the shares are put to you at $48, your real cost is $46.60, or exactly the price you would have paid had you purchased the shares on the open market, at the time of assignment!

(Note: The put buyer may choose to exercise the put if the shares are priced between the strike price and put break-even point, in order to take the smaller of two losses. For example, if XOP falls to $47 at expiration, here are the put buyer's choices:

#1 Allow the put to expire. Put buyer loses $1.40 per share.
#2 Exercise the put. Put buyer purchases shares at $47 and assigns shares at $48, thereby losing $1 per share.

The put buyer may opt for #2 in order to lose $1 rather than $1.40 per share.)

As the put seller, your situation can really turn ugly if the shares cruise south - the proverbial "falling knife" scenario. Every penny the shares lose in value adds a potential penny to your losses. You'll experience a uniquely helpless feeling as you watch the shares drop, constantly wondering when the put buyer will pull the trigger and exercise the put, forcing you to purchase the shares at a big loss. You can of course buy back the put at any time to end the suspense, but you may take a big hit in the process, paying substantially more to close the position than you received when you opened it.

So when, if ever, should an investor sell a put?

Baron Rothschild famously advised that "The time to buy is when there's blood in the streets," which leads to my three rules for put selling:

#1 Only sell puts when the streets are bloody.
#2 Only sell puts in quality, blue-chip companies.
#3 Only sell puts if you think the puts will expire out of the money.

My cue for selling puts is a brutal 500+ point DJIA meltdown day, when panic rules, the prophets of doom pound their chests, and investors run for cover. That's when I go put hunting. I only consider names like JNJ, IBM, XOM, DIS, and PG, great companies whose shares often stumble irrationally when equities go into indiscriminate headlong retreat. Those stumbles drive up put premiums and create excellent opportunities for put sellers.

October was an extremely turbulent month in the markets - prime time for put selling. Here are the puts I sold during October, all of which expired out of the money:

Symbol Trade
Date
Share Price
on Trade Date
Strike Price Premium Expiration Date Annualized Yield
(NYSE:DIS) 10/17/2011 $33.39 $30 $.51 11/19/2011 15.86%
(NYSE:IBM) 10/18/2011 $178.90 $150 $.60 11/19/2011 3.42%
(NYSE:KO) 10/4/2011 $65.23 $62.50 $2.54 11/19/2011 30.35%
(NYSE:PG) 10/4/2011 $63.37 $55 $.78 11/19/2011 9.09%
(NYSE:XOM) 10/4/2011 $72.83 $67.50 $3.26 11/19/2011 36.56%

Notes:

  • Annualized yield calculations reflect a $6.99 commission fee and $.50 per contract fee.
  • I sold two DIS contracts, and one of each of the others.
  • As the yields indicate, these are not kill-shot trades that will get you rich quick. I consider these to be conservative trades that generate moderate supplementary income. The IBM trade yielded merely 3.42% annualized - not much, but still better than parking your money in a savings account or under your mattress (which these days amount to about the same thing.)
Source: Sell Puts When There's Blood In The Streets