We wrote an article earlier this week hinting at how selling puts can make you money while you wait for a good entry price for a stock you want to buy. Given the comments received, and before giving some concrete examples in future article, we though the following principles were worth underscoring.
If you are new to what a put option is, or to the main mechanics of put selling, or if you want to refresh your memory and see a concrete example, you can start by reading this primer. Note that in in this article, we talk about the use of a specific option strategy in the context of building and managing a stock portfolio.
I. Only sell puts on stocks you want to own.
This is the most important risk mitigation parameter of the strategy. Arguably, if you write puts on a stock you strongly believe in the long term, then the "risk"of being put the stock is actually what you may be looking for as it is a way to get long the stock at a discount compared to the current price.
II. Select a strike price consistent with the level at which you would be comfortable owning the stock.
Write puts with strikes below the current price (i.e. out-of-the-money put options). When choosing a strike, you will need to consider the valuation of the stock at that level, and ideally complement this analysis by technical analysis of support levels. You may also choose a level corresponding to a yield you would like to lock-in for that stock. If you believe the stock is currently adequately priced and is poised for a run higher, sell a put very close to the money (i.e. with a strike price very close to the current price) to pocket a bigger premium while increasing the odds of having the stock put to you. This will be a better alternative than an outright purchase of the stock in most cases.
III. Sell when the implied volatility has increased, thus inflating the option premium, hence the money you will collect.
This will generally occur after a pullback and/or when there is increasing fear in the market. When a stock you wish to buy is oversold, this is a great time to write out-of-the-money puts . You will pocket a higher premium and you will increase your chances of the premium rapidly decreasing in value even if the stock does not move as expected. Additionally, if there were to be another leg down in the stock price, this would give you a chance to get long the stock at a depressed value, with great prospects of price appreciation and the possibility to secure a higher yield-on-cost.
IV. Generally look for puts whose premium would yield an annualized return of at least 8%.
This is a rule of thumb. 8% is a decent return on your cash in case the stocks would run higher and no stock put to you. Of course, you still have the possibility to roll up your put in a bull market, still pocketing higher premiums while keeping the possibility to get long the stock at a price you like.
When applying this rule, you have to strike a right balance between risk and return when setting the strike price and the maturity: the lower the strike price, the smaller the risk of being exercised but the smaller the premium. The longer the maturity, the higher the premium, the higher the timeframe during which you are under the risk of the stock being put to you. Again, the latter is of less importance if you like the stock and eventually want being long, hence the importance of Commandment I. Finally, comparing the annualized returns can be helpful: you would rather sell twice 6-month-maturity puts yielding 5% than once a 12-month-maturity put yielding 8%: therefore you get a higher return AND the flexibility to adjust the strike price after 6 months.
Exceptions to this rule can be done for very low beta stocks that you are willing to purchase shortly.
V. Consider buying back the puts if this leads to a higher annualized return.
As time passes, the value of an option decreases. This is called "time decay". The longer the stock holds above the strike price, the higher the chances you will be able to buy it back for a low price and net a profit on the option trade. Of course, if you would prefer having the shares put to you, you would rather not buy back the put and wait/hope for someone to exercise it.
In future articles, we will give some "real life" timely examples of put selling on stocks from our Top 20 Dividend Growth Stocks for 2013.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.