Recently I authored an article in which I recommended going long Apple (AAPL) and taking an "un-hedged" position. I view an "un-hedged" position as one that focuses primarily on upside without too much concern for downside protection. In contrast, a hedged position readily sacrifices upside to gain protection from downside risk.
Now, there are many different ways to "go long" on a stock. One could buy the stock, buy call options, sell puts or engage in exotic variations of options.
First, let me say that if one can accurately predict the price action on a given stock then the best strategy can be easily determined. Show me (or most anyone else, for that matter) the price and time frame of a given stock and there is little problem maximizing profits. The reality is that such precision is not possible and all predictions carry a level of uncertainty.
For purposes of this article I will narrow the focus to put-selling (cash secured puts or naked puts). Other strategies do have their place and I will discuss them in future articles; it's just that I'm choosing to only deal with put-selling at this juncture.
Note: Selling puts is theoretically equivalent to selling covered calls at the same strike. A taxable account may have some advantages using covered calls, but I'll cover that in another article
As a result of the inherent uncertainty in predicting the "what and when" of AAPL's price, the best we can do is come up with some parameters to help us along. This means examining the strike price and expiry date. I will discuss expiry dates in my next article and limit this discussion to setting strike prices.
Put-selling is just an alternate way to own AAPL. It can be viewed as a method that attempts to buy AAPL at a discount to its current price(represented by the "extrinsic" value of the put).
Keep in mind that each put controls 100 shares, so the smallest increment (one put) means you are "conditionally investing" over $54,000 in AAPL. So if $54,000 is too rich, then methods other than put-selling need to be looked into.
The potential "extrinsic discount" usually runs between 2% and 10%, so put-selling is pretty close to outright ownership as far as risk is concerned. This leads to my first "rule" in put-selling: Do not sell puts unless you are willing to buy the stock outright.
Setting the strike price is a balancing act between "extrinsic discount" and upside potential. Setting the strike price at-the-money (ATM) provides the greatest balance. Setting the price in-the-money (ITM) sacrifices "extrinsic discount" for increased profit potential. Setting the strike price out-of the-money (OTM) provides the greatest "extrinsic discount" but the least profit potential.
My second rule in setting the initial strike price is fairly simple. Set the initial strike a level that I would be willing to set subsequent puts, even if the stock goes down in price. For example, if I set the April AAPL strike ATM at $545 I must be willing to set the May strike at $545 even if AAPL falls to $500.
Selling puts is not for "chickens", it is for disciplined investors. That is why selling puts is a strategy for those that feel strongly about the stock and are willing to ride out the bumps. Of course, I can always re-assess my stock position and call it quits or employ another strategy.
In setting the strike I start by looking at the ATM premium to be gained. In the case of AAPL, the April $545 strike credits a premium of $20. This $20 represents around 3.7% of AAPL's current price. This is my maximum "extrinsic discount'.
If AAPL trades at the April expiry below $545 I receive this full discount. Of course, if AAPL falls by more than $20 I have lost some money, but I will always receive the $20 discount to the original trading price.
If AAPL falls in April, I will sell the May put at $545. If AAPL fell as low as $500 the May $545 ITM put would still have about $5 of extrinsic, so my additional "extrinsic discount" is about 1%. If AAPL never recovers to $545 I may lose money overall but I will always better the outright purchase of stock. The strategy didn't fail, it was my bullish assessment that failed.
If AAPL rises instead of falls, my "extrinsic discount" is variable. That is, if AAPL goes up by $10, I only earn $10 more than an outright stock buyer, which represents about 2% discount. If AAPL goes up $20, the stock buyer and the put-seller are on even keel and there was no effective "discount".
IF AAPL goes up by, say $30, the outright buyer earns the full $30, while the put-seller earns only $20. The put-seller has not only lost any "discount" but now must re-enter $10 higher.
This leads to my third "rule": Set the strike as high as you can while maintaining a reasonable "extrinsic" value.
I look at the premium received on an ITM strike of $565 and it's $31. This represents $11 of extrinsic value and $20 intrinsic value. My "extrinsic discount" is now only around 2%. Overall, the $31 potential represents close to 6% upside.
If I look to set the strike too much more ITM, the extrinsic value gets smaller and smaller. I won't set the strike so high that I get less than 2% extrinsic. Do I really want to lose the potential of a big run-up just to get, say, a 1% discount? So, I will set the strike ITM at $565.
This brings us to the moment of truth. Do I believe that next month AAPL will climb from $545 to over $575? What if it climbs to $600? If it does, am I content with $31 and what are my options?
My experience has taught me over and over again, that chasing stocks is a loser's game. I need to ask myself, in advance, a very simple question: If I bought AAPL now, and it went to $600 next month, would I hold or sell?
If I would hold, then put-selling is not the best strategy. If I would sell, then it is. Nothing is simpler than that.
Let's say you sell the April $565 put for $31 and AAPL does go to $600. Since you would be a seller at $600 and you don't want to chase AAPL, simply sell the next months (May 2012) put OTM at $575 for a $10 credit. This premium credit is about 1.7%. That is at an annualized rate of 20% as it can be repeated each month.
But, keep in mind that at some point AAPL will fall by more than $25 and you will be a buyer. Make sure you don't exceed a strike price above where you would be willing to buy.
But what if AAPL continues to climb (some even predict AAPL=$1,000)? Well, put selling ended up as the wrong strategy.
This leads to my next, and probably most important, "rule": Don't use put-selling unless you think the stock will stay within the range of your premium credit. On a hi-beta stock this range is usually capped around 6%, so keep that in mind.
Having covered ITM puts, let me now turn to OTM put selling. I consider this a "hedged strategy" rather than fully long. If the investor doesn't feel strongly enough about the stock to commit at its current price then there are many ways to hedge that can provide a better risk/reward incentive than selling OTM puts.
Nonetheless, this strategy could be employed if you like the stock but are cautious.
Sometimes a hi-beta stock like AAPL can be very appealing for this method. For instance, the April 2012 $500 strike credits $5.60. This strike is nearly 10% OTM and the monthly return is 1.1%. That means you could make over 13% just by selling 10% OTM each month.
Don't be fooled, this is a loser's game. It is still "stock-chasing" but with somewhat less reward and less risk. If AAPL goes up you must systematically raise your strike price and meanwhile you've lost the upward move.
Let me give an alternate. Sell the January 2013 ATM $545 put for a credit of $62.35 (nearly 14% annualized). Right off the bat, you get an average of $6.24 per month with less effort.
If AAPL climbs, you still get the same $62.35 without incurring additional risk of "stock chasing". If AAPL drops, you suffer no loss unless it goes below $483. My guess is that if you sold monthly OTM puts you are likely to get "whip-sawed" under this scenario.
In order to sell OTM puts the strike needs to be set OTM to credit at least 2% extrinsic. Today, this would indicate strikes around $525. Of course, the likelihood of an assignment increases and is probably likely at some point. If that happens, stop selling OTM puts. Sell subsequent puts ITM at that same strike until AAPL rebounds above that strike. Then you can resume OTM.
Conclusion: Selling puts can be a profitable investment strategy. It is my hope to point out that there are many factors to consider (of course this holds true in any strategy). This article deals with what may seem to be the simplest component -- the strike price. I have pointed out some of the concerns but have not, as yet, provided some of the solutions. In my next article I will deal with the expiry date (such as weeklies vs. monthlies) and its relation to strike price, profit and risk. It is only by developing an appropriate understanding of both elements that the reader will be able to construct the most viable strategy..