Generating Year-End Income (Part II): Cash-Secured Puts

by: Parsimony Investment Research

Click here for part 1, "Generating Year-End Income (Part I): Covered Calls."

As year-end approaches, income investors should continue to keep an open mind about various strategies to generate income. Bernanke and the Fed have all but promised at least another year of low interest rates, so yield will be elusive again in 2012.

Our first article in this series discussed the merits of a covered call strategy. This article is focused on selling cash-secured puts.

With a cash-secured put strategy, investors can generate income on large cap U.S. growth stocks with a true embedded margin of safety. Using this strategy, investors can take advantage of the implied volatility in stocks like Apple (NASDAQ:AAPL), Chipotle (NYSE:CMG) and Netflix (NASDAQ:NFLX), which currently have rich option premiums. In addition, these equities have a broad ownership base and tend to be very liquid.

Put Selling Strategy

If you sell a put, you have an obligation to purchase the stock at a predetermined price (strike price) on or before the expiration date (if the buyer of the put option wants to sell you the stock). Clearly, the risk is that the stock drops significantly below the strike and you are forced to buy the stock at a price above market.

That said, below are our two risk management rules of put selling:

  1. Only sell put options on stocks that you want to own at the price you want to own them. With a put selling income strategy (focused on out-of-the-money puts), you get paid to wait for the price you want on a stock. If the price never drops to your strike, you get to keep the premium (income) as a consolation prize. Your downside is owning the stock at the strike price (keep that in mind as you analyze the ideas below).
  2. Don't sell "naked." Just because options offer you leverage, it doesn't mean that you have to use the leverage. We recommend securing your short put position with cash (i.e., don't sell on margin). If you aren't willing to risk the cash to back it up ... don't sell the put.

Generating Income From Growth Stocks

The table below highlights some large-cap growth stocks that are currently ideal for a put selling strategy. On average, the stocks below have a four or five-month premium (income) yield of 7.8% with a margin of safety of 18.8%.

Click to enlarge

This list is by no means exhaustive (there are literally hundreds of decent candidates out there), but it should help you get a feel for what to look for in a put selling candidate. As discussed above, the downside to a put selling strategy is owning the stock at the strike price. So we focused on large-cap growth stocks that we would love to own at a cheaper price.

Beginning this week, we will start publishing weekly put selling ideas for readers to consider (make sure to "follow" us if you are interested in this strategy.

Disclosure: I am long AAPL.