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Understanding The Factors At Play When Selling Puts

I'm a lawyer by profession and so relatively speaking, I am fairly new to trading equities. During the past year I started actively trading options. In general I have found I am a better options trader than I am a stock trader.

The purpose of this article is to reach out to those in a similar situation to mine -- more experienced than the novice investor/trader, but not necessarily quite comfortable with trading (particularly selling) options.

It goes without saying that before you can be successful at trading options you need to understand how options work. There are countless websites, books and other resources dedicated to teaching options at beginner, intermediate and advanced levels.

I am writing this article on the basis that you, the reader, know the basics. Owning a call, like owning a stock (albeit under different circumstances), is a bet that the share price of the stock/underlying will increase. Owning a put, similar to being short a stock, is a bet that the share price will drop.

Having discussed options with those less experienced, more experienced, and equally experienced to myself, I see a pattern that once people "get" this concept, they then try to understand the more complex aspects of options trading, often with little success. We know about the "greeks", we hear about volatility, but I find (having been there myself) that it's not something that is easily integrated into and applied to the strategies that even beginner options traders know i.e. put spreads, or more complex strategies such as my Call Spread with Naked Leg article.

The premise of this article is that, more important than knowing the technical defnitions is understanding the risk reward scenario.

Consider this analogy. Some poker players (Texas Hold'em) can crunch numbers such that they can give you "pot odds", "number of outs" and percentages of winning. Being able to do this is based on a technical understanding of the odds, risks and stakes similar to understanding "the greeks" in options. But even players who can't bark out the technical numbers can still be formidable players if they understand the risk/reward principles at play. More importantly, once a person understands the risk/reward dynamics, it becomes easier to go back and read a textbook or website to learn the more technical side of things.

Make no mistake though, this approach depends a lot on trial and error. For this reason, I would recommend practicing it on a paper trading account before using real money.

Scope of the Article
This article will discuss selling put options. I intend to write a future article on selling covered and uncovered calls but for now we're dealing with uncovered puts.

For this reason, if you are trading with real money, you will need to make sure you have the necessary approvals from your brokerage in order to trade in this way. Unless you have a great deal of cash on hand, selling (or writing) uncovered puts requires you to secure the trade with margin (debt). The reason is simple. Just like when you own a put you get to assign it (or "put it") to someone else at your sole discretion, when you sell a put, you are on the receiving end of this transaction. This means that at any point you can be forced to buy the stock at the sole discretion of the person who holds the put. Accordingly, you'll need to have the cash or margin on hand to accept those shares.

Additionally, you should consider the risk involved in selling puts before you embark on such a trade. Unlike people who own a put and see in a worst case scenario the value of their put erode to zero, the seller of the put will effectively (or literally) need to buy it back at some point at or prior to expiry. This means that theoretically the maximum risk is being forced to buy the shares at the strike price of a company that is bankrupt (and therefore the shares being worthless).

When you consider it though, this is less risky than shorting stocks (which is unlimited risk); the maximum risk is more akin to buying a stock and then the stock going to zero in the near future before you sell it.

Why would you sell a put?
When you think about it, there are two general reasons why you'd want to sell/write/short a put contract.

  1. You want to buy a stock at a certain price below where it is now but want to make some extra money (either free money without buying the stock, or money that reduces your cost of buying the stock).
  2. You think a stock will go up, where others may think it will go down, accordingly you want to be paid for being right.

In the first case, let's use Microsoft (NASDAQ:MSFT) as an example. This stock is a favorite among many shareholders but its performance YTD hasn't been all that hot. Further, if you look at the past 3 years, you see that it's been trading in a range, give or take, between $24 and $30. Nevertheless, it's a big name, with a big product cycle potentially coming out, and it pays a juicy 3.5% yield. Many people would like to own it, but maybe not at this level.

Looking back at the 3 year chart, you'll likely see that the stock price has dipped below $25 from time to time. Let's say you have determined that to be a good entry point. Selling a put allows you to be paid for this hypothesis. On the other side of the trade is likely some scared owner of Microsoft shares who wants to be able to dump it on somebody if it dives below $25. So this person will pay you to be the 'bag holder'. You, however, don't mind because you have decided (in this example) that you want in at 25 dollars.

Selling a put can be for many lengths of time, but, for the purposes of this example let's use a time frame of 3 months (so theoretically you can make this trade once every quarter). If by March (or sometimes even before March) the stock goes below $25, you can be the proud owner of 100 shares of Mr. Softy. Or, in the alternative if the stock never goes below $25 (or isn't exercised while it is below $25) then you pocket $52 for your trouble -- that's better than the $23 you'd make through a quarterly dividend if you owned the shares outright.

Now, here's a second example illustrating another reason why you'd want to sell a put.

Let's use Facebook (NASDAQ:FB) as the example. This was, of course, *the* most infamous IPO of 2012. Maybe you got in on the deal maybe you didn't. Irrespective of whether you did, hindsight says you didn't want to be in that deal as the share price is 30% off the offering price even after a nearly 10% run these past couple months.

But let's say you are of the view that, with Facebook's mobile strategy heading in the right direction and with several of the significant lockups havings passed, maybe this is a stock that will move in early 2013.

You might consider agreeing to buy Facebook shares at $35. Again, we'll use a March time horizon. On that basis, sure you'll be agreeing to purchase the stock about $8.50 above it's current share price; however, you'll be getting about $9 a share as cash in your pocket.

So what can happen?

  • Well you could be right. If Facebook rockets up to it's IPO price by March, you'll likely end up with $900 of free cash.
  • Or you can be partially right; the shares may increase but not up to $35. In this case you'll have to buy 100 shares for $3500 but you'll have $900 in your pocket to offset the loss. So if the share price is $30, you lose $500 on the purchase (assuming you sell the shares right away) but you are up $900, so all in all this is a winning trade.
  • Or, you could be partially wrong. If Facebook shares stay flat or drop moderately (i.e. 50 cents a share or less from where it is now) you'll break even or even make a slight profit.

The premium
In the last example -- the Facebook example -- why would you make a profit even if the share price didn't go anywhere where you had bet on it increasing? This is because of time value.

You may recall that the scared put buyer who bought $35-strike puts from you at $9 per contract was, themself, betting on facebook going down. After all, they were buying a put at a strike price of $8.50 above where the price is now, so what is the extra 50 cents for? That's the price of time.

See, this buyer is paying you, like how you pay your insurance company, that in a certain period of time if something "bad" happens they'll be covered. The longer the time period, the greater chance that such things can happen.

Comparing Companies and Looking at Volatility
I've just gone through two random examples of cases where you might write/sell put options. In the first case, you would be writing an "out of the money" put because, you only make a small premium and you don't benefit much even if the stock goes up substantially. In the second case, you (as the seller of the put) are counting on a sudden move upwards; if that happens, the premium you make becomes cash in your pocket with every dollar increase in the share price.

Now that you understand why you'd want to sell puts, now you should consider being selective in which companies you choose for such transactions.

It is my opinion that the key to being selective is understanding volatility. For those of you who know (or want to know) the "greek" concept relating to volatility, this would be vega.

Some stocks are "steady-eddies" they don't move much in general compared to other stocks. Accordingly, a put buyer is going to be less concerned about sudden swings in prices. For that reason they aren't going to pay much for protection because the stock itself is a "safer" stock than average.

On the other hand, some stocks bounce around unpredictability based on their nature. Accordignly, a put buyer recognizes that this may be undesirable, or may happen at a time when they need to free up cash. For this reason such a put buyer is going to want to pay more for a put.

If you understand this concept, you are well on your way to understanding why a person would want to buy a put. And, like anything you would want to sell, if you know why people want it, you can know how to charge top dollar for it.

Volatility can be measured in a number of ways and you may wish to look this issue up. However, one common way that volatility is measured is through the stock's "beta". Beta is expressed as a number. If the number is "1" it means it's a "1 to 1" relationship with a particular market. As my explanation implies, a beta of 1 means that when the market goes up, all other things equal, that stock will go up in the same manner. When the market goes down, the stock goes down in the same manner. Betas less than 1 but greater than 0 mean that the market and the stock go up and down together but the stock tends to go up less than the market when the market goes up, and tends to go down less than the market when the market goes down. A negative beta suggests an inverse relationship, while a beta of zero suggests no relationship whatsoever.

50 Stocks in the S & P 500
To help illustrate, and familiarize you with a number of different stocks in the S & P 500, I have picked 50 stocks with share prices between $34 and $46. I stuck to companies that are more well known (chances are you have at least one of these stocks in your portfolio already) and stocks which have a multi billion dollar market cap. In doing so, I realize that I was somewhat arbitrary in how I picked these companies. I also realize that in picking large-ish (to very large) market caps, that I am tending to avoid some of the higher volatility small cap stocks, but I think you'll get the idea nonetheless.

You will see from the above 50 stocks (all part of the SPY), that I have included the bid prices for a strike price in February, 2013 which is roughly 10% above or roughly 10% below the current share price of the underlying company. By studying this list (or by creating a list of companies yourself) you can see why some stocks are more attractive to buy puts where other stocks are more attractive to sell puts.

One interesting comparison is The Southern Company (NYSE:SO) and American Electric Power Company Inc. (NYSE:AEP). Both companies are high yielding utilities. They also have similar share prices ($42.82 and $42.79 respectivey).

Both of these companies have a bid of $4.20 for a $47 strike in February. Interestingly enough, the premium edge would go to Southern despite the fact that it's Beta is much lower than AEP's.

In contrast, look at Medtronic (NYSE:MDT) and St-Jude (NYSE:STJ). Both are in the same space with a more closely correlated Beta than our two electric utilities mentioned above. Nevertheless, the lower beta St-Jude, pays a higher premium than Medtronic either in or out of the money.

There are numerous ways that these 50 companies can be looked at. I am just presenting this for your own reference. But it is clear, several companies emerge as having juicy premiums

  • Cliffs Natural Resources Inc (NYSE:CLF)
  • TripAdvisor Inc (NASDAQ:TRIP)
  • SanDisk Corp (SNDK)
  • Garmin Ltd (NASDAQ:GRMN)
  • Lennar Corp (NYSE:LEN)
  • Baker Hughes Inc (NYSE:BHI)
  • Citigroup Inc (NYSE:C)
  • Urban Outfitters Inc (NASDAQ:URBN)
  • Abercrombie & Fitch Co (NYSE:ANF)
  • JPMorgan Chase and Co (NYSE:JPM)
  • Altera Corp (NASDAQ:ALTR)
  • International Paper Co (NYSE:IP)

Of course, looking solely at volatility is no way to make your picks. A volatile stock can go the wrong way too. This article is no susbstite for doing your homework and looking at the fundamentals and technicals of the stocks in question.

Based on the list it would be easy to go straight to Cliff's Natural Resources. It's clearly yielding the highest premium. But right now coal names could go either way. Picking this stock could be more like going to the casino.

My recommendation is to go with retail names such as ANF or URBN.

In the case of Abercrombie, we have some solid earnings growth and institutional buying. For example during the most recent quarter, Citadel Advisors added over 5 million shares shares giving them a 6.3% stake in Abercrombie.

In the case of URBN, nearly 1,200 January 36 puts were bought in over a half hour period on Boxing Day for $0.55, according to optionMONSTER's Depth Charge system. The volume was above the strike's open interest of 997 contracts at the start of the session, indicating that this is a new position.

This is likely to have something to do (at least in part) with Master Card's report that retail targets were falling short of expectations. This shortfall, it turns out, may be grossly overstated. This to me, makes the retail sector fertile ground for selling puts to scared buyers.

Disclosure: I am long FB, JPM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I may initiate an options position in STJ, URBN, ANF or CLF within the next 72 hours