Originally published in partnership with INO.com
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. Here I’d like to focus on leveraging cash on-hand to engage in options trading, more specifically selling covered puts. In laymen’s terms, I’ll cover option variables, an example, strategy and empirical results with commentary.
1) Why buy a stock now when you can purchase the stock in the future at a lower price while being paid to do so?
2) Why buy stocks at all when you can make money on the underlying volatility without ever owning the shares?
Timing the market has proven to be very difficult if not altogether impossible. However creating opportunities to lock-in downward movement in a given stock one is looking to own is possible. If a stock of interest has substantially fallen to at or 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 put option, covered in the sense that one has cash to back the option contract. Leveraging covered put options in opportunistic scenarios may augment overall portfolio returns while mitigating risk when looking to initiate a future position in an individual 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. 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.
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 owners 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.
Variables in Covered Put Options:
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.
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.
The above recent trades are long-term secured puts. What I'm essentially saying is that I'm willing to buy the shares at an agreed upon price (strike price) by an agreed upon date (expiration) while being paid a premium to do so. I offer commentary below for the trades without touching on the fundamental analyses as this is out of scope for this piece. I cover the first three trades and the remaining trades are an iterative process.
1. Nike example above; the stock had sold off from the high $60s to the low $50s and I wanted to take advantage of this sell-off via a secured put with a strike price of $60. Nike remained stuck in the low $50s despite strong quarterly earnings. At this point the contract was at near parity with the premium received and I was assigned shares at $60 less the premium of $8.40 for an effective purchase price of $51.60. No net realized gain was obtained however I now own a high-quality company at prices not seen since in over 18-plus months. I added to a long-term position and decreased my average share price in the process. The stock now trades near $60 thus an unrealized 16% gain on the shares.
2. Disney example above; 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.
3. Target example above; same scenario as my Netflix position 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.
Recent Target assignment - Target missed earnings and the stock sold off thus my covered put was assigned to me at an effective purchase price of $63.54 which was near a 52-week at the time. The stock traded at ~$55 a share at the time of assignment. I lowered my average share price after this assignment to $67.55 from $73.00 or a 7.5% reduction in my average share price. Similar to Nike, I will wait for a rebound off these lows while collecting a 3.55% dividend yield along with an aggressive share buyback program.
Pending Facebook trade – Facebook is currently trading at $140 thus at parity with strike price. I’ll be buying-to-close out this position as the time value decays and the stock continues to trend up.
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. Based on empirical data, I’ve been able to net realized gains utilizing cash on-hand without owning any shares of the underlying company. In the event that the shares do not appreciate, the contract is worthless and shares are assigned. I always choose a high-quality company when engaging in covered puts in the event the shares are assigned. In the case of Nike, I was assigned shares at an effective price of $51.60 and now the shares trade at ~$59 yielding an unrealized gain of $16%. This covered put technique, when deployed in opportunistic or conservative scenarios may augment overall portfolio returns while mitigating risk in a meaningful manner.
Disclosure: The author currently holds shares of NKE, FB, TGT, DIS, CVS and GILD and the author is long all these holdings. 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. The author is the founder of stockoptionsdad.com a venue created to share investing ideas and strategies with an emphasis on options trading.