You don’t have to let the market dictate what price you’ll pay for an awesome company. You can name your own price instead, and get paid to wait for the stock to dip to that level.
That’s what selling put options allows you to do.
When you sell a put option on a stock, you’re selling someone the right, but not the obligation, to make you buy 100 shares of a company at a certain price (called the “strike price”) before a certain date (called the “expiration date”) from them.
They’re paying you for this option to increase their own flexibility, and you’re getting paid to decrease your flexibility.
But by doing this in a smart way, you can get paid to do something you already wanted to do anyway- buy shares of a great company if they dip in price. Then you can hold them for as long or short of a time as you want to.
By selling put options, you can:
- Generate double-digit income and returns even in a flat, bearish, or overvalued market. You don’t need a strong bull market or fast business growth for great investment returns.
- Give your portfolio 10% or so downside protection in the event of a market crash. In other words, if the market drops 25%, your equity positions would likely only drop 15%.
- Enter stock positions at exactly the price you want, and keep your cost basis low. Buy during dips and get a better value than the current market price offers.
Like any tool, there’s an appropriate time and place to sell put options, and other times where it’s not an ideal tactic.
When used correctly, this is a sophisticated and under-used way of entering equity positions, and this article provides a detailed overview with examples on how to do it.
Suppose you want to buy shares of a top-tier railroad company with a strong balance sheet.
Over the last twelve months, it has made $1.80 in earnings per share, and currently trades at $30.50 per share. It pays 50% of its earnings in dividends, over the last ten years has grown earnings by an average of 7% per year with moderate volatility, and there’s no clear catalyst ahead that you expect to significantly change these growth rates. This gives it a P/E ratio of 16.9 and a PEG ratio of 2.4.
First, you need to determine what the fair value of the stock is, using discounted cash flow analysis or a similar valuation technique.
Using the fair value calculator that comes with OptionWeaver, this stock has a fair value of $33.33.
Suppose that after deeper analysis, you decide the business is solid, and that you’d love to pick up shares at a 10% discount to fair value, which would mean under about $30.
That would give you a margin of safety in case the company grows slightly slower than expected, and would improve your overall returns if your growth estimates are accurate.
You could just… sit around and wait and watch, and maybe it’ll come down to $30 or below after a mediocre quarterly earnings release, and you’ll buy it then. Or maybe it won’t come down that low anytime soon, or ever. And for every month that it doesn’t, your cash is sitting on the sidelines and not earning any real returns.
A second method is simply to invest elsewhere. Maybe there’s another railroad trading at a better value that you can invest in instead. Or maybe you found a pipeline company that looks like a great investment at current prices. But what if the whole market is overvalued, and you’re having trouble finding anything trading at a discount to fair value?
The smart method here is to sell one or more cash-secured put options to take on the obligation to potentially buy the shares at a certain price before a certain date, and get paid money up front for taking on that obligation. You obligate yourself to do what you wanted to do anyway- buy the stock if it dips.
The investor that buys the option from you now has the choice, but not the obligation, to decide to sell you the shares at the strike price on or before the expiration date. As the seller, you have the obligation to buy them at the strike price if she decides to exercise the option to sell them to you.
To see current option prices, you just look up an option table, such as on Google Finance or Yahoo Finance or through your online broker. In this example, I’m looking at the put table for an expiration date 3.5 months in the future, and the current share price is $30.50:
Put Table: 3.5 months until expiration
Click here for a bigger version of the image.
Strike: This is the strike price that you would be obligated to buy the shares at if the option buyer chooses to exercise their option to assign them to you.
Price: This is the price that the option has been selling for recently. This is basically how much the option buyer pays the option seller for the option.
Change: This shows you the recent changes in the option pricing.
Bid: This is approximately what you’ll receive in option premiums per share up front if you sell the put. A market maker agrees to pay you this amount to buy the option from you.
Ask: This is what an option buyer will pay the market maker to get that option from him. The difference between “bid” and “ask” is the market maker’s profit. He’s the middle man between option buyers and sellers that makes this a liquid market.
Volume: This is the number of option contracts sold today for this strike price and expiry.
Open Interest: This is the number of existing options for this strike price and expiration. It’s the sum of all option volume leading up to today, minus any option positions that were closed prematurely.
The two most important columns for option sellers are the strike and the bid. The strike is the amount you’re agreeing to buy the shares for if the option is exercised, and the bid is roughly the amount of premium you can expect to earn when you sell the option.
As you can see in the picture, there are all sorts of options at different strike prices that pay different amounts of premiums. And this picture only shows one expiration date- there are other pages for other dates.
In this example, the option that stands out to me as a good choice is the one with a strike price of $30. It’s just below the current stock price of $30.50 and offers a decent premium bid price of $1.43.
Let’s go with this one:
Click here for a bigger image.
If you sell this option, it means you’ll receive $143 now from the option buyer, and you’ll be obligated to buy 100 shares of this railroad company at $30 each if the buyer wants, for a total of $3,000, any time before the expiration date of the option in 3.5 months.
If you sell several options, you’ll be obligated to buy several hundred shares. Each option is for 100 shares.
A conservative investor always has cash available to back this up. You would have $3,000 in cash for each of these options in your brokerage account locked away and ready to buy the shares if they are assigned. This makes it cash-secured. If you do not have the cash available, it would be called a “naked” put, which is highly speculative and not what this guide covers.
In this case, you really need just $2,857 in cash up front, because as soon as you sell the option, you’ll receive the $143 in premiums right away which will bring you up to the full $3,000 amount needed for it to be cash-secured.
So, let’s say you sell this option. Here are your inputs, as well as the potential outputs of what can occur, courtesy of OptionWeaver:
Let’s go over those possible outcomes.
Possibility A: The stock stays over $30 at expiration
If, over the next 3.5 months, the railroad generally stays above $30/share, the option buyer will likely not assign you the shares, since there would be no reason for her to force you to pay exactly $30/share when the market price is already over $30/share. Her option will expire worthless, you’ll keep your $143 premium, and your $3,000 in secured cash will be freed up for selling another option.
Here’s the rate of return calculation if the option expires:
$143 / $2,857 = 0.05 = 5%
You made a 5% rate of return on your initial cash in about 3.5 months. This would be about 18% annualized returns on your money if you do this a few more times for the rest of the year. Compare this to the historical S&P 500 return of around 9%. You’re getting paid a hefty sum of money compared to historical equity returns to just sit around and wait for a price dip for a company you want to own.
Possibility B: The stock declines under $30 at expiration
Let’s say that in 3.5 months, when this option is about to expire, the railroad stock is selling for $29.50/share. So, it dipped a bit. You still get to keep the $143 premium, and the option buyer will assign you to buy the 100 shares for $30 each.
This means that your effective cost basis for the purchase of these shares was only $28.57, which is below your target buy price, like you wanted. You ended up having to buy them for $30 each, but you also received a $1.43/share premium up front, offsetting part of the cost. The net cost basis is that you had to pay $28.57/share, or $2,857 for 100 shares.
And now, you currently own 100 shares of a fine railroad company that currently trade for $29.50 each. You bought a great company at a great price, and now hopefully you can expect plenty of capital appreciation and dividends over time.
Put option risk profile
Selling put options at a strike price that is below the current market value of the shares is a moderately more conservative strategy than buying shares of stock normally. Your downside risk is moderately reduced for two reasons:
- Your committed buy price is below the current market price
- You receive an option premium up front, regardless of what happens with the option or stock after that.
The net result of this is that you’re committing to an effective cost basis that is well below what you’d have to pay if you just bought the stock on the open market today. In the previous example, the market price was $30.50, and you committed yourself to a $28.57 cost basis.
However, as many put-selling tutorials will tell you, selling puts is “risky” because the downside risk outweighs the upside potential. The maximum rate of return you can get during this 3.5 months is a 5% return from put premiums. Your returns are therefore capped at 5%, or 18% annualized if you keep doing it. Your downside risk, however, is potentially very big. If the railroad were to suddenly go bankrupt and drop to $0/share, you’d be forced to buy them for $30/share, which would cost you $3,000. You’d at least get to keep your $143 premium to go out to a bar and buy drinks for your friends to cheer up.
Of course, if you simply had bought the railroad stock normally without any put-selling, you’d be in the same position, except slightly worse. If you own any stock and it goes bankrupt, you can lose your entire investment. And in that case, you wouldn’t even have the $143 premium. Your friends would have to buy you drinks at the bar.
That’s why this strategy necessitates buying high quality companies. I prefer companies that pay dividends, companies that have economic moats, and companies that have weathered countless recessions in the past. Put selling is moderately more conservative than normal stock buying, but you still must pick high quality companies to minimize your downside risk.
I see people teaching different put-selling strategies on more volatile, high-risk stocks with no intention to ever buy them, just to speculate with high premiums, and that’s not something I recommend for most people. I only suggest selling options on companies with a moat and a good balance sheet that you would actually like to own at the right price.
Put selling isn’t about hitting home runs. It’s about hitting a single or a double and getting to base almost every time. You either get paid a nice chunk of extra money for waiting to buy a stock you want at a lower price, or you get assigned to buy the stock at a low cost basis thanks to the option premium. It’s a tool that value investors can use to enter positions in great companies at great prices.
This chart shows the potential rate of returns of this option sale compared to buying the stock today at face value:
The x-axis gives a range of potential prices that the stock might be at during option expiration. The y-axis indicates the rate of return over the lifetime of the option for each ending price, which was 3.5 months in this case. The pattern you see continues off the chart, from zero to infinity.
As you can see, upside potential is capped at 5% for the period (or 18% annualized), but your returns below that point are better than if you buy the stock outright.
Therefore, it’s a strategy not for when you’re extremely bullish, but for when you’re trying to buy the stock at a cheaper price, and when you’re trying to generate income and obtain some downside protection in an overvalued market.
A bullish LEAPS put-selling example
A similar strategy to the above example is to sell longer-term put options that are in the money, meaning the strike price is above the current market price.
“LEAPS” stands for long-term equity anticipation securities. In other words, options that have an expiration date that is more than 12 months away.
The premiums for this type of option will be higher, and thus even though the strike price is higher than the market price, your cost basis if you buy the shares will be considerably lower than the market price.
There are a few main benefits of doing this type of option:
- Because it is in the money, it increases the odds of the option being exercised, while still giving you a lower cost basis on the purchased shares. Exercised options are often more tax-efficient than expired options.
- If the option extends into the next calendar year, it will defer taxes for an entire year.
- It gives you a high upside cap, thus allowing you to be bullish, while still giving you downside protection compared to buying at the current market price.
- During periods of high volatility and high option premiums, you can sell these long-term options to “lock in” the high premiums. If instead you keep selling short-term options, volatility may decrease during the rest of the year and give you lower premiums.
Here’s an example:
Put Table: 13 months until expiration
Click here for a bigger image.
This company engages in oil refining and owns a stake in an MLP for oil transport, currently trades for $29.20 per share, and pays a 4.5% dividend yield. Shares took a big price hit a year ago, as refining margins decreased, and the stock has been roughly flat ever since.
Their balance sheet is strong, and Morningstar analysists are very bullish on the company and believe their fair value to be north of $40/share. OPEC recently agreed to a deal to cut oil production, which has resulted in rising oil global prices, which should benefit this refiner in the long term by increasing their margins.
For this example, we’ll go with the option highlighted in red. If you sell that cash-secured put option for a strike price of $30, you’ll receive $5.50 in premiums per share, and it will expire in 13 months.
If it expires:
If the stock price goes up to over $30 by the time this expires, which is only a slight increase, then you’ll earn a 24% rate of return in 13 months and won’t be buying the shares. And you won’t pay taxes on these premiums until over a year after that.
If it is exercised:
On the other hand, if the stock price is under $30 by expiration, then you’ll buy at $30/share. Your cost basis including the premium will be just $24.50/share.
If you believe the company is fairly-valued or undervalued, then this is a great investment in terms of risk and reward. You could make as much as 24% on your money in a year, and yet you also have considerable downside protection.
If the stock just stays flat all year at $29.20, you’ll buy it in 13 months at a cost basis of $24.50/share, for a rate of return of 19%.
The stock would have to drop a full 16% in price from $29.20 to $24.50 just for your investment to break even. Anything above that, and you make money.
And if the stock price drops a whopping 30%, down to $20.44/share, then your loss would be less than 17% on paper, since you will have paid $24.50 for shares that are now worth $20.44. At that point, if the fundamentals are still sound, you’ll be holding it and can collect dividends from it, so as long as you have a long-term view, you’ll likely do well as the price recovers.
Overall, this is an incredible option as long as you believe the company is a decent holding at around this price in the high $20’s. You can make market-beating returns simply for the stock remaining flat or going up, and you have more than 10% downside protection in case it falls. You’re committing to a cost basis that is about 16% below the current market price.
The right option to sell depends on the scenario. If you’re trying to minimize fees and taxes, and trying to maximize downside protection, LEAPS puts can be the way to go. On the other hand, if you’re trying to maximize premiums, especially in non-taxed or deferred-tax retirement accounts, shorter-term puts can give you a better return.
Selling put options is one of the most flexible and powerful tools in the hands of a value investor.
Rather than buying shares at whatever the market currently offers, you can calculate exactly what you’re willing to pay for them, and then sell the put option to get paid to wait until it dips to that level.
This tactic is excellent for overvalued markets, as well as flat/bearish markets, because you can generate high returns even as the stock price stays flat or falls a bit, and can build 5-10% or more downside protection into your portfolio.
And while it’s not the perfect tactic for a strong bull market, it can be tailored to do reasonably well in that area as well, especially because you can tweak it by selling in-the-money options.