When you see something interesting on the menu that you think might taste great, do you ask a few questions and then try it, or, do you say, "nahhh, I might like it and then I'd want more, so I better not try it."
Options are like that new dish on the menu for a lot of people. Unfortunately, many never will try the dish. And, they'll never get to experience what regular option traders have come to understand: Options, used properly, can reduce risk, generate income, and increase total returns.
Having talked to hundreds of people about options, I know the question that gets asked by almost everybody: "...but aren't options risky?"
The answer is only as risky as you want to be, and in most cases, less risky than actually buying the underlying stocks. In fact, the reason options were invented was to manage risk.
Whether you are seeking to build growth positions while mitigating risk or a retiree who wants both income and growth, this simple strategy can be a core staple to your investment process.
Selling Cash-Secured Put Options
One of my favorite option strategies is a very simple trade that generates portfolio income and reduces equity risk, it is, selling a cash-secured put.
I am going to work through several examples of trades that I have on right now to demonstrate why this simple strategy is so effective. But first, spend a few minutes reading this - even if you are experienced with options:
If you are a beginner, go back to that article early and often.
The key takeaway you should have is that when you sell a cash-secured put, it's a lot like setting a limit order to buy a stock. A big difference however is that you GET PAID to sell a cash-secured put. You get nothing for setting a limit order.
To make the point clear for you, here are some examples for stocks that are on the Very Short List (of companies that can lead in the next decade) at my investment letters. I'll work through this example in full and you can apply to the stocks on the chart below.
CenturyLink (CTL): If you have been reading me, then you know that I like CenturyLink's future due to the expansion of communications in the "smart everything world" that is developing.
Right now, the stock is trading at about $18.32 and the 200-day moving average is at $17.76. Interestingly, the 50dma is just making a "golden cross" above the 200dma, making it a pretty attractive stock technically.
I already own some stock, but if I could buy it a bit lower than today's price, I'd be inclined to buy more. I could set a limit order at the 200dma of $17.76, which is normally a pretty good price to buy at when a stock is starting to move up (or in an established uptrend). My other choice would be to sell a cash-secured put that generates income and gets me an even lower cost basis on a new batch of CenturyLink stock.
In this case, I can sell the CTL July 2018 $18 put for about 80¢. What does that mean?
Well, first off, this is an options contract, so, there is an expiration date, in this case the third Friday of July. Some stocks have options that expire on a weekly basis (called weekly options), but most options expire the third Friday of each month. So, the CTL July 2018 $18 put expires on Friday, July 20th.
Between now and the expiration date, if the price of the stock is under $18, the person who bought the put from me, can make me buy their CenturyLink stock for $18 (the strike price). I am cool with that idea. I'm especially cool with it because, remember, they already paid me an 80¢ premium, meaning my net cost on those new CenturyLink shares would be $17.20 which is far below today's $18.30 and even the possible limit order I would have put in at $17.76.
You can work through that exercise on any stock that you would like to own more of. The very cool thing about selling cash-secured puts is that it becomes recurring revenue. Why? In my experience, by using the 200dma as your target area for setting strike prices on stocks that are in a neutral or positive price trend (this is important, we don't want to try to catch falling knives, more on this later), about 3/4 of options simply expire without assigning you any stock.
Here is a list of stocks and ETFs that I am a seller of puts on or have been recently:
|Stock||Duration||Strike Price||Premium||Today's Price||200DMA||50DMA||Cost Basis If Put|
|Sierra Wireless (SWIR)||July||20||3.90||16.33||19.50||17.17||16.10|
|T2 Biosystems (TTOO)||August||7.50||1.00||7.83||5.18||6.97||6.50|
|SPDR Oil & Gas Services & Equip (XES)||July||19||2.00||17.37||16.02||16.63||17.00|
|SPDR Oil & Gas E&P (XOP)||July||40||1.00||42.41||35.45||38.65||39.00|
A few things before I summarize the rationale on each stock and option trade. First, each trade is different. Why? Because the companies (or funds) and the circumstances are different. There is no "one size fits all" with investing. That's the fatal flaw of indexing by the way.
Also note that the prices are certainly different by now. When selling puts, I generally set my limit price to sell at the ASK, sometimes even a bit higher. Volatility will usually get me filled. If it doesn't, I'll check back tomorrow or the day after or the day after. There's always another opportunity eventually.
You'll notice these are mostly July puts. That coincides with earnings, which I do on purpose because there is movement around earnings and I can adjust my positions accordingly once we get the company updates. Also, I don't like going more than 3 months out.
We can't always get all the way to the 200dma as a cost basis. Sometimes we settle for a net price between the 50dma and the 200dma. Such is life.
While we will usually write (sell) the put outside the money (strike price below current price), sometimes, we will write the put a bit in the money (strike price above current price). Why would we do that? Because sometimes we want a higher probability the stock is "put" to us. More simply, we want the stock, we just want a little discount.
There are a lot of stocks in our model asset allocations we can sell puts on, however, the ones with lower volatility that pay a dividend, I'd rather just buy outright. Stocks like AT&T (T) and Verizon (VZ), while you can certainly sell puts, I'm more inclined to just buy shares on a down day when the price is somewhere between the 50dma and 200dma.
One last thing. Just to show yourself how powerful this strategy is. Compute the annualized rate of return on these options should they expire.
For example: Encana July $13 puts are getting 90¢ in premium. So, divide .90/13 and you get 6.9% for roughly an 8 week holding period. That's an annualized return of about 45% if you just keep rinsing and repeating every 8 weeks. Now, let's say market conditions only allow one trade like that per quarter, that's still an annualized return of over 27%. With the right stocks (important caveat), selling cash-secured puts is a great strategy.
Stock & Option Rationales
Calix: There is not much to be gained selling puts on this stock versus just buying it, so, make sure to buy some Calix. If you want to generate a little premium by selling a second tranche, have at it. This is a stock with very little downside according to the market. How do we know that? If the market perceived higher risk, the premium would be higher. Our job as investors is to know when the market is wrong. In this case, I think it's right. Calix is an execution story. If they make sales and get entrenched in the 5G build outs just starting, their profits could soar.
Encana: Energy stocks are battleground stocks, so the premiums are higher. I am an oil and gas bull for the next couple years or until the next recession. I already own calls and LEAPs, but I could have a few more shares if the price was just right. Of course, collecting premium is great too. I have puts sold at $13 and $14 depending on the account. Folks without much Encana have the $14 strike price because I am happy to have the shares put to them. Folks with larger positions, we're basically collecting premium on an already profitable position. I have written extensively about Encana, most recently here - Oil Is Still Going To $80, and here - Trading Oil And Oil Stocks The Next 2 Years.
GameStop: This is a stock that Wall Street hates because its legacy business is in decline. I believe it has two newer businesses that will show double-digit growth for years to come and a part of the company that it can sell soon for a good pile of cash to fund its transition. I might be wrong, I might be crazy, but I think GameStop rebounds in a big way the next few years as Virtual Reality gaming takes off. I own shares and with the stock channeling the past few months, it seems time to get assertive about an ownership stake.
Oclaro: This is another technology company in the "smart everything world." It is being acquired by Lumentum Holdings (LITE) and should see a lot of business synergies once that is complete in Q3 most likely. The purchase price is set just under $10 per share, but might be adjusted down just a bit. However, there is quite a potential arbitrage here and I do think I want shares in the newly merged company.
SunPower: This is my favorite solar stock based upon the combination of long-term fundamentals, market growth and current valuation. To be sure, First Solar (FSLR) is a great company too, but I think given each company's share pricing, SunPower offers far more upside. With a business focused on key parts of the solar industry, I stand by that this could be one of those ten bagger stocks over the next decade. I'm happily a seller of puts, over and over and over, as I accumulate a double-sized position.
Sierra Wireless: More smart everything world. This time in the IoT connectivity space. Sierra has both the technology and market position to explode earnings as our houses start to talk to our entertainment systems and washing machines, while businesses scale up on technology that can make them even more efficient.
I have sold puts at both $17.50 and $20 because I want to keep accumulating shares to a full position and possible a double position depending on how the company executes in H2. In a perfect world, the stock would be $19.99 on expiration day with one put expiring, one being put to me and all my shares already profitable due to the premiums collected.
T2 Biosystems: This company just got a key FDA approval and then immediately did a secondary offering holding the share price down. This is a unique opportunity to sell puts on this stock at a good price. Remember, it is a volatile biotech and could go lower, so, selling puts to accumulate shares is a good approach. I did this same thing with EXACT Sciences (EXAS) and built a position that ended up being a multi-bagger for all accounts.
SPDR Oil & Gas Equipment & Services: If I am right, and I have been the past couple years, oil will continue to go higher until it settles onto the "peak oil plateau" where supply and demand stay very close for a long time (until EVs break up the party). On that plateau, U.S. shale oil and the Gulf of Mexico are likely to do well. This ETF has a lot of the companies that could do very well the next decade like Helmerich & Payne (HP) which I've discussed below. And readers know I am not very high on offshore drillers focused on deepwater, but this fund gives me a hedge against being right long-term but wrong short-term on a segment that at least in the short run could head up.
SPDR Oil & Gas E&P: This oil and gas exploration and production ETF has been my largest holding for the past year now. While I am up about 25% on the share appreciation, I have also collected premiums 3x now giving us a total return north of 40%. Would you be okay with that over a year? See the articles above, as well as The New 'Golden Age' For Oil Stocks Is About To Begin, to know how well I think this fund could do. This fund was cited at the Sohn Investment Conference by Jeffrey Gundlach of DoubleLine as a top idea.
When I sold the listed put, it was at the money. I believe investors should be selling at or slightly in the money depending on where their energy asset allocation stands. I have recommended 15-25% in energy for most accounts depending on personal financial considerations. That is a considerable overweight compared to the S&P 500's 7% energy weighting, but I believe is warranted at least until the next recession rears its ugly head.
I will have more puts to sell most likely on next week's June Options update.
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Disclosure: I am/we are long CALX,CTL,ECA,GME,OCLR,SPWR,SWIR,TTOO,XES,XOP.
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 own a Registered Investment Advisor - bluemoundassetmanagement.com - however, publish separately from that entity for self-directed investors. Any information, opinions, research or thoughts presented are not specific advice as I do not have full knowledge of your circumstances. All investors ought to take special care to consider risk, as all investments carry the potential for loss. Consulting an investment advisor might be in your best interest before proceeding on any trade or investment.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.