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Writing Cash Backed Puts To Reduce Risk

Writing cash backed puts can produce significantly more income, as compared to just buying the underlying security. I use the term "security" to mean stocks and ETFs and I use the term "cash backed" to mean that you have enough cash in your account to buy the underlying security at the strike price if it is assigned to you. The income generated by writing put options can be several times the dividends that are paid on the very same security that the options are written on. You get paid a premium immediately when you write the put option, instead of having to wait for the dividend to be declared and the payment date to receive the cash. Because the premiums you get by writing put options can be much larger than dividends you would receive by owning the same underlying security, you have to put a lot less money at risk to produce the same amount of income that dividends alone would produce.

There are four reasons why risk is reduced when you write cash backed put options as compared to just buying and holding the underlying security with your cash: 1) You get paid a premium up front, and that money can be re-deployed immediately, and it off sets any loss that you may have to take, 2) you can choose a strike price below the current market price to give you some down side head room, 3) if the underlying security moves in your favor before expiration, you may close out the option to lock in your profit by buying back the option. This eliminates your exposure and frees up your cash to look for other opportunities, and 4) The option price is less sensitive than the underlying security, until it gets deep in the money. This helps you to exit a position with a fraction of the loss that you would have incurred had you just owned the security.

The Trade Off

When you sell cash backed put you receive a premium, however, in exchange for this premium, you do give up the potential capital gain that the security could produce. When you write the options and the price increases beyond the strike price, you do not participate in the capital gain beyond the strike price. If your objective is to generate income rather than benefit from a potential capital gain or you have trouble selling before you can capture this capital gain, then writing options makes sense.

The Importance of the Premium

The table below compares a put premium to the quarterly dividend on 6 popular dividend paying stocks as of January 18, 2013. The time to the April 20th expiration date approximates a quarter. The ratio of income produced by the put options to the quarterly dividend averages 3.3 times, with a high of 4.7 times.

 

Current

Strike

April 20, Put

Quarterly

Income

Ticker

Price

Price

Premium

Dividend

Ratio

           

MSFT

$27.25

$27.00

$1.08

$0.23

4.7

INTC

$21.25

$21.00

$0.92

$0.22

4.2

HCP

$46.48

$45.00

$0.95

$0.50

1.9

JNJ

$73.23

$72.50

$1.43

$0.61

2.3

PEP

$72.48

$72.50

$1.88

$0.54

3.5

PG

$69.94

$70.00

$1.72

$0.56

3.1

Why is it so important to be able to generate a larger return with an options writing strategy as opposed to a smaller dividend with dividend paying stocks?

Risk Reduction Example:

You can make a reliable 4% dividend with a portfolio of quality dividend paying stocks.

You can produce a 15% return by writing put options on the same high quality dividend paying companies.

You need to generate $15,000 a year of income.

With the put option writing strategy, you would need to risk $100,000 to generate $15,000 a year. With a 4% dividend yield strategy, you would need to risk $375,000 to generated $15,000.

Assume something bad happens quickly in the market and it declines 20% in a very short amount of time (think 1987 crash). Let's also assume that this occurs in October after ¾ of the year has past.

In both cases you earn ¾ of $15,000 or $11,250 of income. With the option strategy the principle has just declined by $20,000. So at this point the put option strategy is underwater by $11,250-$20,000 or -$8,750, or 8.75%. With the dividend yield strategy, a 20% decline in your principal amounts to $75,000. So relying on dividends to generate the income you need, you are underwater by $11,250-$75,000 or -$63,750, or 17% on a much larger amount at risk. Both the premium and a dividend are helpful in off setting the loss, however, you do not have to risk as much money with the put writing strategy.

Summary

I believe that writing options is a better income producing strategy than owning dividend paying stocks, mainly because you have to put less money at risk to generate the same level of income.