A Portfolio Strategy For Long-Term Success: Selling Puts

Includes: CLF, EEM, FCX, IWM
by: The Financial Lexicon

Selling puts is one strategy that can lead to long-term investing success. As part of any diversified portfolio, investors will have several allocations and strategies which are used to meet their long-term goals. I think the strategy of selling puts with just one to four weeks to expiration many times over the course of a year can be quite a rewarding strategy for long-term investors. Remember not to confuse long-term investing with buy-and-hold investing. Buy-and-hold investing is just one way for a long-term investor to meet his or her goals. There are other ways as well. The investor who learns how to sell puts on fundamentally sound companies over a period of many years can, in my opinion, absolutely outperform the broader-market during that time.

In my December 9, 2012 article, "Consider Selling Puts On These 3 Stocks," I said the following:

"In the world of options, a patient investor willing to collect small amounts of money over and over can easily come out ahead of other investors who spend their time trying to capture larger returns from a position. For a seller of options, looking for opportunities with just a couple of weeks to go before expiration can sometimes yield surprising results. While making 1% to 2% over a two-week period may not be a very exciting trade, if the strategy is repeatedly executed over the course of a year, an investor can realize large annual returns."

Furthermore, I offered ten specific strike prices at which investors could have sold puts on Apple (NASDAQ:AAPL), Freeport-McMoRan Copper & Gold (NYSE:FCX), and Cliffs Natural Resources (NYSE:CLF), all of which had expiration dates just two to three weeks into the future. I am happy to report that the put options at all ten of those strike prices expired worthless, thereby providing investors who sold those puts the maximum possible return. Remember that as a put seller, you realize the maximum return possible on the position when the option you sell goes to zero (expires worthless).

In this article, rather than present more put options that I think will expire worthless over the coming weeks, I would like to provide a series of things to keep in mind when searching for put options to short. If your long-term strategy for growing your portfolio over time will include selling put options, I hope you will find the following helpful in your decision-making process.

1. Choose companies that have adequate fundamentals. By adequate fundamentals, I mean the company must not be in any danger of failing over the short-term. When I chose ten strike prices to offer as ideas for selling puts on Apple, Freeport-McMoRan, and Cliffs Natural Resources, I was of the opinion that all three companies had adequate fundamentals to not only survive the upcoming few weeks, but also to avoid abnormally large sell-offs in the stocks during that time.

2. Choose companies you wouldn't mind owning for a period of time should you be assigned shares of the stock. But if you are assigned shares of a stock and want to exit the position without taking a loss, there are plenty of hedging strategies to help you do just that.

3. Diversify - never go all-in with one company. Diversify your short-put-option allocation across multiple companies. In the aforementioned article, I used three companies (Apple, Freeport-McMoRan, and Cliffs Natural Resources). I think three companies is the minimum number an investor should use when executing this strategy consistently over a longer period of time.

4. Remember to consider broader-market ETFs as well.

5. Do your best to avoid selling puts that expire after an upcoming potential market-moving event. For example, we are currently just a few days away from kicking off earnings season. If you are looking to sell puts expiring later this month, be sure to avoid companies reporting earnings prior to options expiration. The goal is to avoid events that have the potential to move a stock in a big and unpredictable way. Executing this strategy successfully over the longer term involves capturing the easy money and should not be confused with event-driven trading.

6. After you've chosen the companies and expiration dates to target, look at near-term support levels, and sell puts below those levels. This is exactly what I did with Apple, Freeport-McMoRan, and Cliffs Natural Resources in the aforementioned article. Again, the key to successfully executing this strategy over the longer term is to increase the odds that put options you sell will expire worthless. By targeting strike prices below a stock's support levels, you can greatly increase the odds of success.

7. Higher beta stocks often have higher volatility levels on the options. This helps to pump up option premiums, thus allowing you to capture more premium, even on further out-of-the-money options. According to NYSE.com, Apple's beta is 1.21, Freeport-McMoRan's is 1.94, and Cliffs Natural Resources' 2.37. If you are an ETF investor looking for beta, consider iShares' Russell 2000 ETF (NYSEARCA:IWM), which has a 1.20 beta, or the iShares MSCI Emerging Markets ETF (NYSEARCA:EEM), which has a beta of 1.38.

8. Higher market-wide volatility levels will also help to increase option premiums. One way to measure market-wide volatility is through the VIX. Selling put options when the VIX is elevated may help to increase your returns. It would also allow you to go even further out-of-the-money to capture the same type of premiums you usually do, thereby providing more of a buffer between the current price of a stock and the strike price you choose to sell.

As a long-term investor, you should be well aware of a variety of strategies that can help you achieve your goals. Some people choose to do fundamental research on companies and buy shares. It is also possible to do fundamental research on companies and instead meet your investment goals by selling puts and capturing smaller returns over and over. In fact, by consistently selling out-of-the-money puts, I would contend that investors can earn 10% or more in a year (on average, 0.833% per month) with lower risk than outright share ownership. After all, your worst case downside scenario is being forced to buy a stock at a lower price than you otherwise would if you opted not to sell puts and instead bought shares.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long Cliffs Natural Resources and Phelps Dodge (FCX) bonds.

About this article:

Author payment: Seeking Alpha pays for exclusive articles. Payment calculations are based on a combination of coverage area, popularity and quality.
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here