I so look forward to early spring. Mother Earth has thawed, and mild breezes pull me to my garden for invigorating honest labor. However, what I like more than anything is that the beginning of spring is the perfect season for selling put options.
In this article I will describe basic put-selling strategy, the spring advantage and three trades I am planning that will illustrate the potential benefit.
Put Selling 101. Now I know that many readers have an aversion to the "O-word," so maybe we should first clear up a few misconceptions. Indeed, you have probably heard that about 90% of option buyers lose money. Also, the venerable Chicago Mercantile Exchange occasionally publishes statistics, and they report that consistently 75% of their options just expire unused. What that means is 75% of the option writers, or sellers, were paid a premium for their option contracts and never had to make good on them. The option seller has a proven advantage as time works in his or her favor.
Another misconception is that only investors versed in "high finance" can write options. First, there is no writing involved, the mechanism is as easy as buying stock on an online broker account. However, while anyone can usually sell covered calls, you have to request clearance from your broker to sell puts. That is the velvet rope that keeps this very lucrative strategy available only to the elite. It is worth contacting your broker because this level of option trading is quite common. Get on the other side of the velvet rope.
Normally, you will probably need to maintain free cash in your account equal to 10 to 30% of the value of the underlying stock to guarantee your out-of-the-money put until its expiration. The amount is determined by the broker and will change with the stock's daily movement.
Early spring is my all-time favorite put selling season. You may have heard the expression of "sell in May and go away." This ditty relates to the fact that historically over the past 40 years, the months of March, April and May are three of the five most positive months of the year for stocks. Puts are more likely to expire during a rising market, so selling now with expirations around June makes theoretical sense. Of course, each year is different, but 2012 is shaping up to potentially follow the pattern.
On that note, I must say that I was about to give up on this put-selling season. The market's upward winter grind has dropped the volatility index too low to incubate option prices. Part of an option premium is based on the volatility of the stock, and a low VIX makes put selling similar to selling flood insurance in a drought. In fact, many of the put buyers are actually just buying insurance on their holdings, so a little "fear factor" helps inflate the premiums the put seller collects.
Fortunately, we have finally been blessed by a disturbing market drop, and the VIX is heating up just in time to make for a promising put-selling season. While simply selling puts for income is perfectly reasonable, the most conservative method is to sell puts in stocks that you actually would like to own. Now lets look at a few examples.
Alon Energy (ALJ) is one of my favorite stocks that I have never owned. Last year I doubled my money selling puts in this company, so Alon is fertile ground for this strategy. ALJ is a vertically-integrated refiner and marketer of gasoline. It owns combination convenience stores/gas stations in the southwest. It expects 7% revenue growth in 2012 with a forward PE of 7.5. It has other superior value metrics such as more than $12 in sales for every $1 in market cap. At this writing it sells for $9.30 per share.
My strategy is to sell 10 of the June 7.50 puts for $50 each. In order to earn the $500, I will have to freeze an additional $750 in my broker account until expiration. Doing the math, that is a 66% return on my money in 3 months, or 264% annually, without compounding! Sweet.
Oh incidentally, some think that ALJ has an advantage because it has contracts that supply "sweet" crude from Texas, and Louisiana, which is better for refining than "sour" crude from most other places.
If the stock drops below the strike price, I will have to buy it at $7.50. Deducting the $.50 I collected for the put, I will get the stock for about $7 per share, plus minimal broker fees...a bargain. At that price, my cost will be about the book value of the stock. Technically, the stock appears to have support at the strike price.
This is an example of an interesting small-priced stock that offers a fat option premium and low margin requirements. One difficulty is that these often have little option float, so liquidity can be an issue if you need to buy back the contract. If you want a larger trade, I suggest another good refiner, Valero Energy (VLO). There is more option float, and the fundamentals are similar.
My second example is OCZ Technology (OCZ), selling for $8.20 per share. This company seems to have taken the lead in solid state drives for ultra-light Ultrabooks. This year's revenues are growing at a 90% rate, and the forward PE is 15 per analysts. I really would like to own OCZ for a long-term investment. I am OK if it drops below my June $7.00 strike price puts, which will pay me $75 per contract. The worst that would happen is that I will get a growing, state-of-the-art tech company for the discounted net cost of $6.25...a PE of 11.
If OCZ continues to go up in value, as I expect, I will be able to collect $750 on my ten contracts, freezing my margin money of $2100 for three months. This equates to a 35% return in 3 months or 140% annually without compounding.
This is an example of a high-flying stock that would be a good addition to the portfolio at its current price. It is subject to volatility, and the strategy of selling its puts allows the investor to either collect a nice premium in cash or buy the stock at a deep discount to its current price. A win-win either way.
The next example is a stock that is in my radar screen, but I am not convinced I should take it at its price. On the other hand, I do not want to lose the opportunity, as I do think it could rise in price in the near future because of growth prospects and value fundamentals.
I have never been too excited about advertisers, but I think Interpublic Group of Companies (IPG) has adapted well to important macro factors: the digital networking age, expansion of media and global demand for their services. My bias against these stocks in the past is that I like tangible equipment, products or commodities. Advertisers "sell the sizzle and not the steak." I am slowly changing my perspective, and I look at IPG as maybe sitting in the sweet spot where a lot of money will be going in the next decade. Also, I think that I am not alone in my skepticism, and, if my new perspective is correct, IPG deserves a better PE than 11.5. It sells at $11.33 today.
I will reach out to the July 10 put buyers, which will pay me $500 for 10 contracts, and I will have to put up another $1000 margin, according to my broker agreement. If the put expires, that will yield 50% return in 4 months or 150% annually.
If it comes all the way down below the strike price, my net cost will be $9.50 and I am comfortable taking a risk on my first advertising stock at that price.
In conclusion, put selling in the springtime is a great hobby to develop as long as you know the potential consequences. There is never a guarantee that there will not be a huge refinery fire, a revolutionary technology shift or loss of a key customer that will force you to pay up for a stock that no longer is attractive. On the other hand, investors need every edge they can get, and the option sellers have time on their side. We did not discuss the technical aspects, but a glance at the chart can help determine if the stock has support above the strike price of the put: for instance, a moving average or heavy volume at a certain level.
That being said, puts carefully sown now can yield an abundant harvest of cash in the summer.