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Tom Armistead
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I am a retired accountant, having spent the early years of my career in the insurance industry and the later part in the field of accounting. My insurance experience has given me the willingness to accept investment risk if I feel the return justifies it; also, an interest in applying risk... More
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  • Selling Puts As A Substitute For Fixed Income 17 comments
    Jan 9, 2014 9:13 AM

    Recently I looked at the U.S. High Volatility Put Write (NYSEARCA:HVPW) ETF, attracted by an article that touted it as an investment for "prudent income investors." The prospectus is somewhat less inviting, describing it as a "speculative trading instrument." But it still raises the question, can selling cash-secured puts substitute for fixed income?

    HVPW writes puts on the twenty large cap names with the highest volatility, 15% out of the money, with a two month duration. The puts are secured with treasury notes. The distribution rate is aspirational, at 9%. No estimate of maximum losses is provided, although the prospectus warns about possible complete loss of investment capital.

    I looked at this idea several years ago from the point of view of a dividend-oriented investor, and studied the likely outcome of a portfolio that sold puts on dividend stalwarts 10% out of the money, with a three to six month duration. I estimated that such a portfolio would produce 4.5% annually, with very infrequent drawdowns maxing out around 18%. Of course a dividend-oriented investor would not be too upset, being forced to buy at a market bottom.

    I also simulated the use of less than full cash security, resulting in proportionately higher returns and drawdowns.

    Implications for Synthetic Dividend Growth Portfolio

    The Synthetic DGI Portfolio has been working as expected, with one exception: the calls sold gave away the upside on a larger number of positions than I was looking for. Briefly, the results of the twenty names selected were more dispersed than I thought they would be.

    Another issue, what to do with the cash reserve, was resolved by buying vertical calls spreads, both legs in the money, on stocks that were selected for a combination of volatility and margin of security. That's been working well, returning 12.8% while maintaining cash sufficient to support the exercise of all long calls. This is a cowardly way of selling puts, in that such positions are easier to deal with in declining markets.

    Since the LEAPS which are the starting point for the Synthetic DGI Portfolio are at strikes averaging 80% of the share price, leverage starts at 5:1. Selling covered calls at strikes and expirations that provide income equal to the dividends, effective leverage to the upside is reduced because of the upside that is not realized.

    After reviewing this, I plan to greatly reduce the sale of covered calls, and replace the income by either the sale of cash-secured puts or the vertical call spread strategy described above. Theoretically, the 5:1 leverage will replicate capital gains and losses on the underlying. Meanwhile, using a portion of the 80% remaining cash to secure the sale of out of the money puts (or the equivalent), the income received will replace the dividends forgone by using the LEAPS as substitutes for share ownership.

    Incidentally, the 12.8% on the vertical call spread strategy includes stepping in the way of a sharp sell-off in Cisco (NASDAQ:CSCO), precipitated by horrendous guidance for the current quarter.

    Under normal market conditions, this portfolio would replicate the results of owning the shares, other than the taxable nature of the income received. There are defensive advantages in a declining market, in that the LEAPS can be rolled down for less than the difference between the two strikes, resulting in a profit on the roll, or a reduced loss when compared to owning the shares.

    The difference lies in the returns to be received from the cash held aside. In more normal markets the money could be placed in Treasuries or corporates at some reasonable rate of return. With rates where they are, using the money to support the sale of puts seems like a viable alternative.

    Substituting Vertical Calls Spreads for the Sale of Puts

    Please consider the following trade on Corning (NYSE:GLW).

    (click to enlarge)

    This is effectively the sale of a put, in that I bear the risk that the stock will be below $17 at expiration. GLW has a very strong balance sheet and a history of increasing the dividend. I would most likely exercise the $13 call at expiration, for a net cost of $15.67 per share.

    In the event something funky happens, if GLW gets down to the $13 area before expiration, time value will increase and cushion the loss. At that point, the position can be rolled down to pocket the time premium, or closed for proceeds of about 70 cents. Note the $9,100 I had available to exercise the call is intact, plus whatever salvage I get from closing the position. The downside is defined here, unlike with the sale of a put, where it theoretically extends to zero.

    Leverage Rears Its Lovely Head

    Note that the plan here is to have all puts (or equivalents) fully cash secured. The way I operate, it's not unlikely that at some point studied carelessness will result in positions that are less than fully cash secured, in the interest of improving returns.

    I had hoped to make $100,000 behave like $250,000. As a practical matter, the way I'm doing it I need to use about $160,000.

    What About All Those Covered Calls?

    After concluding that the sale of covered calls hurt my situation last year, I don't intend to buy back those I have already sold that expire this year. The thinking is, now would not be a good time to correct the situation. First one thing works, then another.

    As the situation stands, I'm controlling $270,000 worth of dividend paying shares, well-known names. Total account value is about $175,000, with $110,000 in cash. I expect to earn 9% on the cash, which is 3.9% of the value of shares controlled and exceeds the dividend income that the shares would generate if I owned them.

    As such, the covered calls aren't necessary to achieving the income objective, and are interfering with the capital appreciation objective. With the market near record highs, and shuffling back and forth nervously so far in January, I plan to leave the calls out there, but will discontinue rolling them. In the even of a market sell-off, they can be bought back at a profit.

    Disclosure: I am long GLW, CSCO, .

    Additional disclosure: I'm a retail investor, and blog in order to expose my thinking to critical examination and comment from readers, and as a way of talking shop. I'm writing about what I do with my discretionary investments, and not giving advice of any kind.

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Comments (15)
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  • Clayton Rulli
    , contributor
    Comments (3424) | Send Message
    Wish articles like thid could still be published., I would probably write a lot more! Check out DPO for the opposite strategy, Call writing!
    9 Jan 2014, 09:24 AM Reply Like
  • Tom Armistead
    , contributor
    Comments (6225) | Send Message
    Author’s reply » Me too. Something like this is work to write it up, then there is very little audience and commentary on the instablog. Cash secured puts is a legitimate and common strategy for dividend-oriented investors, who look at it as getting paid to place a limit order.


    I left it out of the article, but looking at positions for HVPW as reported to the SEC they are providing downside protection on some situations that may have substantial downside and limited bounce.


    Thanks for the idea on DPO, I'll take a look.
    9 Jan 2014, 09:30 AM Reply Like
  • loonsong
    , contributor
    Comments (341) | Send Message
    Tom, i've been retired for 14 years now and selling naked puts has been part of my income strategy more than ever. i started selling naked puts in the '80s and fine tuned my approach as i went along.
    now i bring in about $ 7500.00 per month.
    DE and IBM are perfect candidates. i buy the stock and then sell puts underneath it. DE 65's, 70's and 75's and IBM 145's and 150's.
    i sell the puts only on things i want to own and at a price i would be happy to own them. if the stock is attractively priced i establish a 50% position and keep selling the puts.
    over 25 years, only 1 in 10 puts have been exercised. its been a big plus for me and if used in a disciplined manner, it can be very rewarding.
    thanks for your thoughts,
    9 Jan 2014, 10:52 AM Reply Like
  • Tom Armistead
    , contributor
    Comments (6225) | Send Message
    Author’s reply » loonsong, thanks for your comment. Selling puts the way you're doing it is an effective strategy, basically you're getting paid to place a limit order on something you would like to buy (at the right price).


    I have to admit I'm very cautious on selling puts, the reason being I got very badly burned doing that as the financial crisis built to a head. I'm well informed on insurance companies, which is where I made my mistakes. I didn't appreciate exactly how bad the situation on RMBS and the rest of the alphabet soup was on the books of some of the less careful insurance companies.


    Under current conditions I considered selling puts on blue chip dividend growth stocks but elected to go with something similar in high volatility tech stocks with strong balance sheets, mostly because there was higher volatility and higher premium.
    9 Jan 2014, 11:05 AM Reply Like
  • loonsong
    , contributor
    Comments (341) | Send Message
    i am not too knowledgeable on tech, so i keep it simple: puts on csco, intc, msft, and swks. i generally use a 20% less than market strike and i try to stick with dividend payers with real earnings.
    the only two insurance cos. i sell puts on are CB and TRV. same rules, and i don't force a sale if nothing attractive is available.
    also, when puts get down to a quarter or i've made 80% or more, i cover early and book the trade.
    also, when something gets creamed, like VMW did last year, i take a look. but i don't make a move until i've done the intrinsic value work and feel positive at the strike i am selling. BBBY's drop today is one i'll look at
    with an eye to selling a 55 put in jan 2015. PE there might be 10.50 and they buyback. it pays the bills.
    have a great day,
    9 Jan 2014, 11:21 AM Reply Like
  • Robin Heiderscheit
    , contributor
    Comments (3291) | Send Message
    Tom, I think it is hard to make an argument that the market currently is underestimating future historical volatility in blue chips IF you are selling that volatility more than a couple of months out. OTOH it appears your strategy is to sell the front few months, which is probably okay, even though implied volatility is so low. At least that is Bill Luby's (whom you should follow) contention.


    Anyway, I would rather buy in the money call spreads at this point because at least you are buying about the same amount of implied volatility as you are selling.
    9 Jan 2014, 11:47 AM Reply Like
  • Tom Armistead
    , contributor
    Comments (6225) | Send Message
    Author’s reply » Robin, I follow Bill Luby but haven't been paying much attention, just sort of running along with the same strategies I've used for years.


    I've been selling the covered calls fairly far out, like 4 to 7 months, 8% out of the money, not a good idea in a low volatility market that has been trucking along at 30% up for the past year. My counterparties do not thank me, they just pocket the money and go on to the next case.


    I prefer spreads to one sided trades, as a general rule, on the grounds I don't have to think that much about volatility, since I'm both a buyer and a seller. I'm more of a directional trader.


    So as a rule of thumb I'm betting for a stock to go up, while earning time premium faster than I'm paying it. Last year I missed the macro call, since I wasn't looking for anything like the market increase that came out. Hopefully this year will be different, and spreading will work better.
    9 Jan 2014, 12:21 PM Reply Like
  • dancing diva
    , contributor
    Comments (2752) | Send Message
    Tom - I like the strategy of selling puts and have used it, but am wary at this point since volatility is so low. At this point I'm keeping the dates closer (versus selling puts a year out one year ago) and am largely only employing it for the more defensive sectors. If/when we ever get a decent correction of close to 10% I'll be more aggressive.
    9 Jan 2014, 01:54 PM Reply Like
  • Tom Armistead
    , contributor
    Comments (6225) | Send Message
    Author’s reply » dd, there are a lot of us who would kind of like to see that 10% correction, I'm totally spooked after last year, waiting for the correction that never came.
    9 Jan 2014, 04:31 PM Reply Like
  • amfox1
    , contributor
    Comments (27) | Send Message


    Thanks for the instablogs.


    I use a variety of puts and calls to hedge around my dividend positions. Currently have cash-secured puts on ABX and POT offsetting long-dated call spreads on both. I have also had (but do not have currently) CSPs on DE and EMC recently.


    I mostly use covered calls on my positions. Old-line tech stocks such as EMC, CSCO and MSFT have been very profitable, as were retailers such as M and KORS prior to Christmas.


    I currently have 30 companies with options positions, of which 21 expire in Jan or Feb. Given the possibility of a correction, I have been trying (like diva) to keep the expiration dates within 60-75 days, except with respect to repair situations and where the puts finance long-dated call spreads.
    9 Jan 2014, 05:34 PM Reply Like
  • okifarmer
    , contributor
    Comments (5) | Send Message
    Tom - Thanks for the article, well thought out and expressed. Capping the downside and earning income while providing a lower entry point for something you would like to own is what options are all about. Low volatility challenges our creativity using the options tool. In this market, where at least some qualified observers believe we've come to fuller value, I've been buying long put diagonals on companies rated by both Value Line and Morningstar to be overvalued on a number of criteria. The short put compensates for the time value of the long. Since portfolios by their nature are mostly long a percentage of these provides something of a hedge plus adding income through time decay. At a time where tech may be vulnerable I guess I'm making by bets in a different direction.
    9 Jan 2014, 06:52 PM Reply Like
  • Tom Armistead
    , contributor
    Comments (6225) | Send Message
    Author’s reply » okifarmer, I like the diagonal puts idea. I've used it, sparingly, on the grounds that it gives you some staying power on the short side and doesn't involve borrowing shares and paying dividends.


    Now might be a good time to have some of those positions.
    9 Jan 2014, 07:03 PM Reply Like
  • Valueplay98
    , contributor
    Comments (582) | Send Message
    Great instablog - I had not heard of HVPW before - I only write puts on small caps, so this ETF is definitely worth a deeper look.


    Just out of curiosity ... why couldn't this get published now ?
    10 Jan 2014, 08:40 AM Reply Like
  • Tom Armistead
    , contributor
    Comments (6225) | Send Message
    Author’s reply » Valueplay, I didn't submit this as a regular article because SA is not accepting articles on options. They gladly accept articles on ETFs, so in retrospect I could have made the content more about HVPW than I did. I'm coming at it from my interest in options.


    I was able to track down filings which included the options holdings, some of the names included caught my attention, TSLA, CRM and HLF, to name a few. My impression was that you could have a number of years of very good results, with the occasional bad year if the market should crash.


    I was concerned that recent articles on HVPW were not properly presenting the speculative aspect of this ETF, and have been presenting it to types of investors for whom it would not be suitable.


    At the same time, the product should be of interest to some investors with a more speculative outlook. It's like writing insurance against natural disasters, you could have many good years and the occasional bad one. I couldn't come up with a constructive approach to making the distinction as far as who should consider buying this thing so I let it pass.


    I guess I'm saying that what I'm doing seems better for me than buying the ETF, probably the main reason is I get to pick and choose where I write puts.
    10 Jan 2014, 09:33 AM Reply Like
  • Tom Armistead
    , contributor
    Comments (6225) | Send Message
    Author’s reply » A number of commenters mention the extremely low volatility that we're experiencing right now, and that does raise the question whether selling options is a good source of income, for the fact it's hard to get enough premium.


    Looking back to 2009, those were the good old days (in retrospect), premiums were generous and it wasn't that hard to get direction right, if you could stand being bounced around a bit.


    Logically it's a better time to buy protection to the downside, or maneuver to limit downside.


    On the other hand, selling covered calls you are providing a service and getting paid to do so. So even when it turns out that I sold the upside on something that does very well, I figure I earned the premium, plus I made money on the underlying.
    10 Jan 2014, 09:47 AM Reply Like
  • lpjblb
    , contributor
    Comments (41) | Send Message
    Tom--regarding the Leaps in the synthetic portfolio, do you believe the stock's dividend is fully priced into the option price?
    15 Jul 2014, 09:36 AM Reply Like
  • Tom Armistead
    , contributor
    Comments (6225) | Send Message
    Author’s reply » I tend to think of the time value of LEAPS as interest on a notional loan of the amount saved vs. buying the shares. So if an in the money LEAP with a strike of 70 had $1.50 in time value for one year, I would think of it as 2% interest and a cost of staying long the stock.


    So your question is about the accuracy of Black-Scholes and its variants, not something I understand fully. I've been able to make money using my thought process.


    Owning LEAPS, I like to cover the time cost involved, either by the sale of covered calls or lately more by investing the money I would otherwise have spent buying the shares. Whether I can fully replace the dividend income is a question that would be easier to answer if bond rates were higher. I would simply invest the difference in corporate bonds.
    15 Jul 2014, 09:47 AM Reply Like
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