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  • Lucrative Profit Opportunities In Selling Exchange-Traded Options As Insurance 2 comments
    May 2, 2014 10:34 AM

    Lucrative Profit Opportunities in
    Selling Exchange-traded Options as Insurance

    What is it?

    A seller of put options is selling insurance on a regulated exchange and collects a premium for assuming the risk of having to contractually commit her capital to purchase the stock on which the put was sold at the given strike price.

    These are transactions with a timetable where you enter into a distinct contract that has a finite and measurable payoff by a known date (usually a few months). This payoff is partially contingent on the company you've written the premium on but just as importantly, on time.

    The way to look at making money with selling puts is to apply a set of cascading risk reduction protocols that increases the probability of collecting the premium without an assignment event. In essence, making time work for you, regardless of the longer term fortune or tribulations of the company.

    There will be losses in this sort of investment operation, the goal is to use these guidelines to produce a reasonable annual profit. I will go into what to do when you are in a loss situation as well.

    Risk Reduction Protocols

    1. Always write put options on companies that you like and have analyzed fundamentally. This is a powerful layer of protection. Study balance sheets and financial statements. You want simplicity and quality. A good starting point is to look for tangible book values (and I'll explain how this ties in with the strike price of the put you'll write). As a put writer you give up participation in the upside of an investment that could be quite good. You are a realist. You believe that earning 20%-40% each year will make-up for any long-term holding of stock. In some ways, this strategy may be even safer since time is an added component which can work for you. I can't stress this enough. Don't write on junk companies, or overvalued companies, or complex companies. Keep it simple.

    2. Try to find stocks of smaller or mid-size companies trading in 5 cent increments only. Fame and size are not always your friend in writing insurance premiums. I've found the sweet spot to be smaller to mid-cap stocks between $200 million and $2 billion market cap. You want to go where there is less competition and where you may have an edge in the stock. You don't need 1 cent increments as it will only serve to distract you.

    3. Watch for companies buying back stock. The buying back of stock is a very powerful element of writing put premiums. This is very similar to the concept of nominal vs. real returns. When there are major corporate events, option contract terms are sometimes adjusted. However, the steady, or even major purchase of stock is often not a major corporate event and option prices are not adjusted for this event. As a consequence, over a period of time, a company may retire stock and even if it were to tread water for a while, nominal stock prices would have a floor or resistance even if in real terms nothing is changing. Combine this with a 6-9 month put option and you have a very powerful catalyst to put a floor under the stock price - which serves to protect your premium since your strike price is also quoted in nominal terms. Likewise, try to find non-dividend paying stocks since you want the retained earnings in the company to support your strike price and maintain your safety margin.

    4. The put option should be deep out of the money in exchange for a reasonable premium and - equally important - produces a good return on the collateral requirements of your broker. You are an insurance writer. Your primary goal is not to be assigned but rather to pocket the premium. However, deep out of the money needs to be correlated with the financials of the underlying security. For example, the strike price may represent a discount to tangible book value of the company. My broker has a tool that allows you to estimate collateral requirements prior to selling the put.

    I look for a 20% return minimum on collateral. I don't use all these "justifications" that I can annualize my return. 5% in 3 months is 20% annualized is still 5% - for now. Let's be pragmatists here. You don't know what will happen after your insurance contract is expired. What you know is this medium-term investment available right now. I also look for a put that is out-of-the-money by at least 20%. (This is not a hard rule because what's more important is the discount in relation to the valuation of the company. However, even if the tangible book value supports only a 10% margin to strike price, you may want to limit option writing to the amount that may be assigned - volatility is a very real concept). There is no need to stretch here. There are always opportunities that provide a deep discount to a conservative estimate of value and a reasonable premium. This is partially due to the overall macro environment, but also to the individual security. It is important not to delude yourself or to push the limits on one transaction when there may be more favourable ones now or in the near future. Like the self-help gurus say about life, we must look to the internal not the external as from the inside all truth will flow. Same here - have an internal benchmark of requirements and then see if they exist in the world. If not, wait. Sometimes you'll have to change your expectations but wisdom is knowing what is actually happening.

    5. I've read a study and experience has shown that there is no point to go out too far in terms of time. There are as of this writing excellent premiums to be had in a 6-9 month time frame. Why go out 1 to 1.5 years with a LEAP when you can meet your return requirements in 6-7 months? Always be scanning to see if you can meet your benchmark return with the shortest time to expiry. There is a place for LEAP writing. Premiums may be very advantageous. Furthermore, as there is more time, even shorter term volatility is unlikely to result in assignment if the option is near the strike price. A more important factor is locking in a rate of return. With short term options, once the return has been achieved, a new opportunity must be found.

    6. Some people add another layer of protection which is to only sell options one is willing to have assigned all - or a portion at the strike price into stock ownership. This may not be a bad thing given that you've selected the company and the strike price with a margin of safety. Another philosophy is to be so conservative that you write more options than you can afford to be assigned and hope to use the emergency tactics listed below.

    7. Finally, there is something to be said for a small amount of diversification with this strategy. It is, however, not a style I advocate if the above criteria have been found in a single opportunity. Since it is rare to find the perfect situation, some diversification can protect you but as we saw in financial crises, it is by no means a certainty.

    8. Even with the above protections, one may still choose to maintain an excess liquidity buffer. I suggest always having two numbers in mind instead of one. The first number is what you would like to have as the default liquidity - or collateral excess. The second number is what you would be prepared to allow your liquidity to dip to if a juicy opportunity occurs while you are invested in the normal state.


    Risks Associated with this Opportunity (In case of emergency...)

    - Dramatic decreases in stock prices in a short time frame are possible.

    - You may have misjudged the value-selection criteria of the underlying security.

    - A market shock could occur.

    It has been said 90% of options expire worthless (~30% at expiry date and another 60% closed out prior to expiry. Note that of the 60%, some positions may be in a loss situation). That's good to know and the risk protocols advocated will further increase the probability of a suitable outcome. The mechanics of option assignment are a sort of lottery system. It doesn't always happen when the strike price is hit before expiry (although it is mandatory to assign if below the strike at expiry) and you may not be assigned all your contracts. This is a theoretical area as it hasn't happened to me yet.

    My thinking is that you would want to take even a small loss to prevent assignment and roll-over into a lower priced put. The lower priced puts will increase in price as the stock drops so you will take a loss on the higher priced put you wrote in exchange for securing an even lower strike with less chance of exercise. This is the contingency plan I use in the case of a breach of the above mentioned risk protocols.

    The first rule of emergencies is to try to not get into them which means to choose your battles carefully and follow the protocols above. The next rule is to be opportunistic. What may appear as a large loss in closing out a position may offer the opportunity for a new position that is even better. This is a business and losses should be factored into the ultimate return you expect. Better yet, have no expectations and seek out good deals that appear to be mis-priced.

    The following variations are useful in certain specific circumstances. I would, however, not use them unless there was a very compelling reason to do so. The key to success and few headaches is to keep it simple. Selling deep out of the money naked puts is the simplest.

    Alternative #1:

    You own an equity position but are unsure which "horse will win the race".

    Horse #1 - put writing earning 20-40% per year

    Horse #2 - leveraged stock ownership on an S&P500 stock with 30% maintenance margin requirement. Such a stock only needs to move 8-10% per year to produce an equivalent return as the put writing.

    Ideally you would like to do a little of both strategies but are never sure whether the stock will take off - or you may not find a suitable deep out of the money situation as described in the first section above.

    You could sell an In-the-money put option instead of owning the leveraged stock position. In this scenario you actually want to collect a large premium and fully expect to be assigned.

    The premium received up-front from writing the put option can be used to satisfy collateral requirements. Since the premium is quite large, this provides substantial excess liquidity for also betting on Horse #1 (in moderation).

    After 6 months - or if there are LEAPS even better - you will be assigned and take a leveraged position in the stock. By this point, you will have wound-up the put venture so that you have enough liquidity to assume the new stock position.

    Alternative #2:

    Short Strangles

    The CBOE Education centre says this about short strangles,

    "This strategy is really a race between volatility and time decay. Volatility is the storm which might blow in at any moment and cause extreme losses. The passage of time is a constant that brings the investor every day a little closer to realizing their anticipated profit. "

    This is a wonderful description of insurance underwriting. A strangle is a 2 leg strategy of which the short naked put is 1 leg. The other leg is a short naked call. A short naked call profits from premium income when the stock price does not rise above the strike price until expiry. A short strangle is a "negative" profit. It is not so much that you make money if the stock rises or falls near or through your strike price, but rather that the opposite contract's premium income offsets the loss from the assignment or buying back of the opposing position. If the stock trades between the twin pillars of the strike prices you've selected, you will earn some multiple of the profit of using only a naked put. If the stock falls to your strike price, the compensating profit from the naked call will offset part of that loss. It is more conservative than only a short put.

    My inclination is to overweight the put and underweight the call - as well as being conservative in selecting the strike price (higher for a call) then you might initially consider. You may also choose the naked call expiry date 3 months prior to the short put.

    Another benefit of a short strangle is the broker collateral requirements. In fact, brokers will reduce the margin required for the short call position if you already hold a substantial short put position in the same stock. If you choose a relatively high out of the money call to short, this can produce a very reasonable return on collateral roughly equal to the premium received on the call. I believe the expiry dates of both the call & put have to match for this collateral matching to occur.

    Given that the premiums for the call will be smaller than the put you write and you have to keep some focus on two variables, I think the pay-off of this strategy is only marginally better than just selling puts.

    Other Details

    - Your broker will set aside collateral. This collateral is interest free, unlike a margin loan. It also decreases if things go well.

    - If things go well, you may be able to close your position 2-3 months ahead of expiry. Sacrificing some loss to get back your collateral may be warranted if a new opportunity presents itself. 5 to 10 cents may be worth the price.

    - Taxation of these contracts vary. In Canada, it is as follows: If you sell the puts with a strike past December 31st, you must claim the total premium as a capital gain (or on account of income if you are doing this as a trading operation) in that year even though you have realized no profit. The next year, you will claim a loss if you buy the option back to close the position before expiry. (There is some debate if selling US put options on account of capital must appear on a T1135 form - see comment below). Since the timeframe is 6-9 months and you plan to hold to expiry or close near to expiry, I would consider these transactions on account of capital. What matters is consistent treatment and not to over-trade. One trade to enter, then an exit in 6-9 months. You want to do this as an investment operation and this document will help with treatment -

    - Conceivably, you could do as little as two 6 month trades per year, each yielding 15-20% on collateral for a yearly return of 30%-40% (minus whatever losses incurred - and they will occur from time to time).

    - This strategy works well for people who want to have a measurable time-table for their activities. It can be psychologically difficult to wait years or indefinitely to see the result of your decisions. In selling puts, you can create "man-made" benchmarks at the 3 month, 6 month, 9 month mark and you can see your result with the seasons.


    The tools that I use are Interactive Brokers for low option commissions, low margin rates, best platform, and overall most incredible business partner an investor could ask for!

    I also like this put selling option screener - , although it is only a first pass. There are good companies and options that did not come up using this screener because it cannot do fundamental analysis. Conversely, there are some very good contracts that can be spotted very quickly using its features.

    Good luck and please let me know if you have any questions or have found this strategy to work for you!

    Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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Comments (2)
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  • 106232
    , contributor
    Comments (8) | Send Message


    Nice article. Very well written.


    I have used a conservative put option selling strategy for several years now and I have benefited from it.


    Find good companies I would not mind owning and sell out of the money puts. I also do it with companies I own to add extra income, like getting a dividend.


    So, do you recommend IB for DIY investors? Others always say it is for day traders only. Anything negative surprises I should be aware of regarding their service?


    I was also intrigued by your statement:


    "Also, for US options, you will not need to list them on T1135, a distinct benefit over stocks with the new requirements."


    I agree but what is your reasoning behind this and have you seen any official document or ruling to support it. I ask because so much I read and hear seems to conflict and be based on interpretation of the CRA definition of Specified Foreign Property.


    “a property that is convertible into, exchangeable for, or confers a right to acquire a property that is specified foreign property”


    I feel that uncovered put writing is an obligation and not a right (as is call buying) to acquire a property. Your thoughts?


    Going further, I also assume you would not include the capital gains/losses you receive from uncovered put writing on the T1135.




    14 Apr, 06:01 PM Reply Like
  • scorpion.north
    , contributor
    Comments (221) | Send Message
    Author’s reply » Hi, thanks for the comments. I do recommend IB for investors because this is a case of what is good for the day trader is even better for the investor. Primarily, the benefit of IB for an investor will be the lowest interest rate if one chooses to borrow money, a very low transaction cost and a pretty good platform. Watch out for minimum opening requirements and the new RRSP and TSFA products they just made available seem to require Canadian funds to open (i.e it's not a $US RRSP or $US TFSA).


    As for the T1135, I don't have any online reference. On looking at a T5008, for example, the cost basis appears to be the premium proceeds and the proceeds are whatever is realized on closing the position or letting it expire (0). However, on the account screen, the position appears as a negative value that closes out to cash when the transaction is closed or expired. So one could say that if the premiums written are over $100,000 it may be worth consulting a tax advisor. The difference with a put, however, is that unlike a call, you are the writer/seller and only the buyer has the right to exercise (which they usually won't if it's above the strike price). Furthermore, if it's below the strike, the assignment is some sort of lottery system by the clearing house. A call buyer always has the right to exercise, even if it makes no economic sense. So it seems a put is some sort of contingent obligation in which the option seller has zero say - but the expectation of an outcome - based on certain variables. I'll make a note in the article there is some debate on it, thanks for bringing it up.
    16 Apr, 06:33 PM Reply Like
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