Cash-Covered Put Selling: 1 Response To Zero Returns On Cash

| About: ConocoPhillips (COP)

Anyone with a brokerage account knows that cash held in an account, awaiting better stock-buying opportunities, is earning effectively nothing these days. One way to realize a return on some of that cash is to sell puts on stocks that are "covered" by those funds. In this article I will review the basics of this strategy, and offer my own opinions on when it is appropriate, and to what extent. I will then review five put sales that I have entered and exited over the past two years on one stock, ConocoPhillips (NYSE:COP), to illustrate how I have employed the strategy, and the results achieved.

Most income investors are familiar with the strategy of selling calls on stock owned for additional income. If the call expires worthless, the realized call sale income adds to the dividend income, assuming the stock is a dividend-paying stock, boosting the over-all return. If the option is assigned and the stock must be delivered to the option buyer, the call seller is "covered," by virtue of already owning the shares that must be supplied. The only downside is that the call seller will forego any gains in excess of the call's strike price. Frequently, in the case of early exercise, the seller will also lose out on a dividend that was expected, as an alert option holder exercises the option just before the ex-dividend date, forcing the shares to be sold via assignment.

The strategy of selling puts on stock you don't own may be less familiar to income investors. Whether the stock is owned or not is actually immaterial to the put selling strategy. In fact, it is probably better if it is not owned. When a put is sold, the seller receives cash immediately, in return for a commitment to buy the stock at the option strike price, if assignment should occur. This commitment is ongoing until the option expiration date. Since a put sale is a conditional purchase, if assignment occurs, an additional 100 shares will be owned for each put sold. As to why it might be better if the put seller does not already own the stock, it is because the portfolio may end up over-weighted in that name, as the shares acquired from assignment are added to previous holdings. The only way for the put seller to be "covered", in the same sense as the call seller is covered under the covered-call selling strategy, is to maintain cash in the account sufficient to buy any shares that might have to be purchased via put assignment, including commissions. In an IRA, this will be required by the brokerage. In a margin account, the cash required will vary by brokerage. As a conservative investor, I would recommend always maintaining cash balances adequate to cover any put assignments that might occur, to avoid margin calls.

The key conditions for considering a put sale are: the stock must have been evaluated as a desirable holding; the put can be sold with a strike price sufficiently below the current market that a purchase at that price represents a good value; and the proceeds from the put sale are enough to make the trade worthwhile, at least $1.50 to $2.00. Attractive put selling opportunities are more likely to be available when the market over-all has been pulling back, and the stock in question has declined from recent highs.

ConocoPhillips has satisfied my put sale criteria on numerous occasions during the past two years. I have sold puts on COP five times, and I actually have been disappointed, to a certain extent, as each trade went in my favor - I really wanted to own the stock, if shares could have been purchased at the put strike price(s). The specifics of each trade are detailed in the following table:

With the benefit of hindsight, I can see that I exited the first two trades too soon. I actually came to that conclusion at the time, and determined that I would not exit in the future unless I could make at least $100 on the trade, a rule that I adhered to for the latter three trades. It is interesting to observe that the lowest annualized return of the five trades was the one where the option was held to expiration and expired worthless, which was the original goal when entering these trades in the first place. These results just vindicate my thinking, which is that a "take the money and run" approach makes a lot of sense in options trading, as long as the exit is not premature, and the return is adequate.

Under this put selling strategy, only three things can occur, all nominally good, at least when viewing the world as it existed at the point of the put sale. One possibility is that the stock makes a favorable move relatively early in the trade, and buying the put back yields enough profit that it is worthwhile to close out the trade early and be done. A second possibility is to wait it out to expiration, and let the put expire worthless, thus exiting the trade with no additional expenditures. The third possibility, the worst case, is that the put is exercised and the put seller is assigned, purchasing the stock at a substantial discount from the price the stock was at when the option trade was entered. Further, in this worst case, the put seller still retains the initial put sale proceeds. As Yakov (famous comedian of Ukrainian descent) would say, "what a country." So why not sell puts against essentially all cash in your brokerage accounts, since the strategy works so well? Think back to the reason why an investor keeps cash in a brokerage account in the first place - to have "dry powder" available, so opportunities which arise can be taken advantage of. Having too many open put sale trades, with essentially all available cash committed, could be very detrimental if an unexpected, severe market decline should occur. The investor could see all available cash being used up buying the stocks upon which puts had been sold, at prices that are above the market, even though these prices were once thought of as representing good value. Since nearly all cash would be expended honoring put contracts, there would be no funds available to take advantage of new buying opportunities that would likely be appearing, as the decline gathers steam. Every individual investor must weigh all the pros and cons to determine the cash levels to be held awaiting opportunities, and then, if puts are to be sold, a maximum proportion of that cash to be pledged via cash-covered puts. In my case, I limit open put purchase obligations to no more than 20% of available cash.

In conclusion, selectively selling puts covered by a portion of brokerage cash is a viable strategy for generating a return on some of that cash, but the investor must realize and accept the purchase obligations assumed when selling puts, and weigh how much of available funds to commit to the strategy, considering the investment objectives and risk tolerance.

Disclosure: I currently have no open short put positions. I will consider initiating a short put position or two upon a market pull-back, if and when one occurs.Regarding COP, the stock featured in the article, I would want to see COP decline below $70 before I would consider a new put sale on COP.