High Quality Secured Puts Yield 20% Return

January 2, 2017

Originally published in partnership with INO.com

http://www.ino.com/blog/2016/12/high-quality-secured-puts-yield-20-return/#.WGntVfkrLIU

 

Overview

 

I’ve written many articles highlighting the advantages options trading and how this technique, when deployed in opportunistic or conservative scenarios may augment overall portfolio returns while mitigating risk in a meaningful manner. Timing the market has proven to be very difficult if not altogether impossible. However creating opportunities to lock-in the downward movement in a given stock one is looking to own is possible. If a stock of interest has substantially fallen to near a 52-week low, then one has an option to “buy” the stock at an even lower price at a later date while collecting premium income in the process. Alternatively, it's also possible to make money on the option itself without owning any shares of the company via realizing options premium gains as the underlying stock appreciates in value off its lows. This is called a covered or secured put option, covered in the sense that one has cash to back the option contract. Leveraging covered or secured put options in opportunistic scenarios may augment overall portfolio returns while mitigating risk when looking to initiate a future position in an individual stock or looking to make money on the potential appreciation without owning the stock. In the event of a covered put, this is accomplished by leveraging the cash one currently has by selling a put contract against those funds for a premium. Why buy a stock now when you can purchase the stock in the future at a lower price while being paid to do so? Why buy stocks at all when you can make money on the underlying volatility without ever owning the shares?

 

Secured Put Example

 

Selling a put option will take on the obligation to purchase the shares of interest. For instance, he/she is taking on the obligation to buy the shares at $105 a month from now when the current price is $100. The seller of the put contract believes the shares will appreciate beyond the $105 level. Thus the owner of the shares would not exercise the option and assign shares to the put seller if the shares appreciate beyond $105. Why sell the shares at $105 to the put option seller when the owner of the shares could sell them on the open market for a higher price than $105? In this case, the put option seller collects a premium from the put option buyer and still makes money without owning any shares. From the stock owner’s perspective, he/she is buying the right to sell the shares at $105 a month from now when the current price is $100. The buyer of the put contract believes the shares will fall below the $105 level. Thus the owner of the shares would exercise the option and assign shares to the put seller if the shares fall below $105. Why sell the shares below $105 on the open market when the owner can sell them to the put seller for $105? This is effectively an insurance policy against the shares falling. In this case, the put option seller collects a premium from the put option buyer and assigned shares that may be significantly lower than the market price.

 

Secured Put Strategy

 

When it comes to engaging in secured put selling (e.g. willing to buy shares at an agreed upon price by an agreed upon date while being paid a premium), I search for unique opportunities in high-quality names typically in the large-cap space that have sold off due to largely extraneous factors unrelated to the fundamentals of the company itself. I focus on companies that are growing revenues, possess great growth potential, have an acquisitive mindset while returning value to shareholders via paying out dividends and buying back its own shares. There are exceptions to this rule for high-growth stocks such as Netflix and Salesforce that can provide great returns in the options market after a double-digit sell-off. Typically, I look for a correction in a given stock due in large part to extraneous factors (i.e. political backdrop, weak foreign data, currency issues, etc.) or a narrow earnings miss. This is seen often times and recently stocks such as Nike, Target, Disney, Starbucks, Apple and CVS Health have declined dramatically. This is where I'm willing to "buy" high-quality names at 52-week lows via an option contract in hopes of a rebound in order to net a realized gain without owning the underlying stock. If assigned then I own a high-quality name which was purchased at a 52-week low.

A Few Characteristics to Keep in Mind for Secured Put Options Trading

1. Strike price: Price at which you have the obligation to buy the stock (seller of the put option) or the price at which you the right to sell your stock (buyer of the put option).

2. Expiration date: Date on which the option expires

3. Premium: Price one pays when he/she buys an option and the price one receives when he/she sells an option.

4. Time premium: The further out the contact expires the greater the premium one will have to pay in order to secure a given strike price. The greater the volatility the greater the time premium received for covered call writing.

5. Intrinsic value: The value of the underlying security on the open market, if the price moves above the strike price prior to expiration, the option will increase in lock-step.

 

Netflix, Target and Disney Examples

 

For Netflix Inc. (NASDAQ:NFLX), I was willing to buy the shares at $110 however I was paid $15.56 per share to take on this risk. Regardless of the market value, if the shares were assigned to me at $110 my effective share price would be rendered to $94.44 ($110 less $15.56). Netflix shares shot past $120 after its most recent earnings announcement with only a few days left on the contract. As the shares appreciate beyond the agreed upon price of $110 the contract becomes worthless since the owner of the shares would have no incentive to sell them to me for $110 if she can sell them on the open market for $120. I chose to buy-to-close the position for $0.10 to close the contract prior to expiration to net a realized gain of $1,546 or yield of 14.1% ($15.46/$11,000 leveraged or earmarked to potentially purchase the shares). These realized gains were over the course of 8 weeks utilizing cash on hand and never owning any shares of Netflix.

 

Target (NYSE:TGT) presented a similar scenario as Netflix with the exception of the fact that Target is a well-established large-cap stock with a dividend yield and thus premium yields are usually less lucrative for these types of stocks. Despite the less lucrative premiums, the same principles apply. The stock had sold off from the mid $80s to the mid $60s and took advantage of this sell-off via a secured put with a strike price of $72.50. Target blew away the numbers and the stock was propelled higher and broke through the strike price to the high $70s. At this point the contract was near worthless and I decided to buy-to-close the contract at $0.67 to capture ~90% of the contract value. Net realized gain was $549 or a yield or 7.6% ($5.49/$7,250 leveraged or earmarked to potentially purchase the shares). This gain was realized over the course of roughly 4 weeks utilizing cash on hand and never owning the underlying shares of Target.

 

For The Walt Disney Company (NYSE:DIS), the stock had sold off from the low $120s to the high $90s and took advantage of this sell-off via a secured put with a strike price of $100. Disney propelled higher and broke through the strike price to the mid $100s. At this point the contract was near worthless and I decided to buy-to-close the contract at $1.08 to capture ~90% of the contract value. Net realized gain was $818 or a yield or 8.2% ($8.18/$10,000 leveraged or earmarked to potentially purchase the shares). This gain was realized over the course of roughly 7 weeks utilizing cash on hand and never owning the underlying shares of Disney.

 

 

 

Summary

 

Through engaging in secured put trading and targeting high-quality names, I’ve been able to generate a 20% return in a relatively short period of time. Searching for high-quality names that have sold-off in a meaningful way where the fundamentals are largely intact, present compelling opportunities for these types of trades. In the event that the stock does not appreciate and the shares are assigned then one owns a high-quality company at or near its 52-week low. These types of trades can make a meaningful impact on one’s portfolio and or lock-in purchases at or near 52-week lows when building a portfolio

Noah Kiedrowski
INO.com Contributor - Biotech

Disclosure: The author currently holds shares of DIS and TGT the author is long DIS and TGT. The author has other secured put contracts that are currently open. The author has no business relationship with any companies mentioned in this article. He is not a professional financial advisor or tax professional. This article reflects his own opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. Kiedrowski is an individual investor who analyzes investment strategies and disseminates analyses. Kiedrowski encourages all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback, the author values all responses.

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