Selling Put Options: Sell Puts to win in any market scenario

Selling Put Options: A smarter way to invest?

I have previously written about an article as to why value investors should also be options traders, specifically the “art of selling put options” to generate passive income as you wait for the RIGHT price to purchase your ideal stock candidate.

That is what selling put options is all about and as “complicated” as it might sound, it is actually a simple process that can usually be executed with a few clicks of the button using a brokerage platform that allows for options trading.

In this article, I will be touching on 2 key strategies when it comes to selling put options. The first is to sell puts to buy stocks at a discount and the second is to sells puts to trade.

What do you mean when you Sell Puts?  

In the options world, there are 2 main types of options: Call Options and Put Options. Concurrently, you can either be a Buyer or Seller or both of these 2-types of options. Let’s talk specifically about selling put options, which is the key topic for today.

When you sell a put option on a stock such as AAPL, you as the SELLER, first and foremost, are entitled to receiving a PREMIUM. This is money into your pocket from the get-go.

However, once you received this premium, you will now have an OBLIGATION. That obligation is to BUY X number of shares of a company at a certain price (strike price) before a certain date (expiration date) from the BUYER of this put option contract.

This obligation is NOT a certainty. In fact, in the majority of the cases (80-90%), the buyer of this put option, while having the RIGHTS to sell X number of shares to you (seller of the Put option contract in this instance), will not have the incentive to do so.

Hence most of the time, the put option which you sold expires worthless, which is good for you since you have already received the premium (aka: selling at a high price and buying back at ZERO) when you executed the trade.

By doing this in a smart way, as a put option seller, you can get paid to do something you always wanted to do – buy shares of a good company at the RIGHT price.

That is why I said in my previous article that all Value Investors should also be options traders, specifically to sell puts and get paid to buy a good stock at the right price.

By selling put options, you can:    

• Make money in 3 out of 4 different scenarios. 1. Stock appreciates, 2. Stock stays flat, 3. Stocks decline slightly. Only in the 4th scenario where the stock declines substantially will you lose money.
• Consistently generate high single-digit or double-digit annualized returns as you wait for the right price to buy your right stock
• Use Margin of Safety or MOS to give your portfolio some downside protection. You can choose to sell a Put option contract at 10% below the current price of the stock. For example, if you wish to own shares of AAPL but do not wish to pay the current price ($127), you can choose to sell a Put Options contract with a strike price of $115 (approx 10% lower than the current price) with a horizon of 6-months, receiving a premium of $800.

If AAPL is below $115 on contract expiration in 6-months, you are happy to buy 100 shares of AAPL at a cost of $115. If AAPL shares is above $115, your put option contract which you sold becomes worthless and your profit is the full $800 premium you originally received.

When used correctly, this is a simple but yet often under-utilized way of buying stocks “at a discount”, something which all value investors should engage in.

The key risk associated with selling put options for beginners is that they tend to get “greedy” and over-leverage. Note that the minimum contract size for options is 1. 1 Option contract however entails 100 shares.

Hence, by selling 1 put option contract, one is essentially potentially getting exposure to 100 shares of stock. This might not be an issue for a “low priced stock” but for a relatively “high priced stock” like AAPL, selling 1 put option contract could mean taking on the obligation to buy 100 shares of AAPL, which at the current price amounts to $12,700 in value.   

When it comes to selling put options, I engage in 2 key strategies: 1. Sell Puts to own a stock at a discount and 2. Sell Puts for trading purposes, with the goal of generating a consistent 15-30% return annually.

Let’s first talk about the first strategy: Sell Puts to own a stock at a discount.

Sell Puts to own a Great Stock at a discount

One of the stocks that I love and have the intention to buy and hold onto it long term is Microsoft. I will not be doing a deep-dive analysis on Microsoft but suffice to say, this is probably a big-tech stock that is “NOT CHEAP” but will likely “NOT GO WRONG” as a long-term stock in one’s portfolio.

In fact, Microsoft is the ONLY company that has consistently maintained its position as the Top 10 largest company by market cap over the past 3-4 decades.

So, I have got every intention to own at least 100 shares of Microsoft but I am not willing to pay its current price of $212 even though the fair value of the counter, according to my favorite stock screener, Stock Rover, is at $231/share. The street also has an average target price of $244/share on Microsoft.

Let’s say I wish to purchase 100 shares of MSFT at a price of $200/share, which is approx. a 10% discount from its current share price level. That will give me a good margin of safety in the event that all the analysts out there are DEAD wrong on the fair value estimate of MSFT.

There are a few things I could do. I could just sit around and wait and watch and pray for the price of MSFT to come down to $200/share (perhaps a bad quarterly results) and buy it. Or maybe it will never come down to that price in the near term and for every month that it doesn’t, my cash is sitting on the side-lines and not earning any real returns (or at least I will not be at risk of making losses).

The second method is to find another comparable stock to MSFT that is trading at a better value that I can invest in instead. But what if the whole market is overvalued (like the current tech market) and I am having trouble finding anything trading at a discount to fair value?

The third method and the smart method here is to sell one or more cash-secured put options on MSFT. I will now have the obligation to buy 100 MSFT shares at $200/share (which is my original intention) and get paid money upfront for taking on that obligation.

I will thus sell a Put Option on MSFT, with a strike price of $200/share, expiring in 6 months-time in July 2021.

For that trade, I will receive a premium of $1,240, which translates to an annualized return of (1,240/20,000)*2 = 12.4%.

If MSFT trades below $200/share on expiration in 6 months’ time, I will be happy to pay $200/share for a quality company like MSFT.

If MSFT does not trade below $200/share on expiration, I leave with $1,240 in my pocket. Not a bad deal as well.

Some quick terminology explanations:

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.

Last Price: This is the last traded price that the option has been selling for recently. This is basically how much the last 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.

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 “mark” price which is what we should always be targeting to BUY or SELL the options at.  

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

When I sell 1 put option contract on MSFT, I will be obligated to purchase 100 MSFT shares at the strike price, in this case, at $200/share. A conservative investor always has cash on hand when he/she sells a put option, thus, the term “cash-secured put”.

For this particular example, it’s $20,000. If I don’t have sufficient capital, that does not mean I cannot execute the trade. In most instances, I will probably require just 20-30% of the $20,000 capital to execute this sell put trade. However, this sell put trade now becomes a “naked” put, which is significantly riskier.  

What could happen?  

Scenario 1: Share price of MSFT is at or above $200 at expiration

If over the next 6 months, MSFT share price stays above $200/share, the Put option buyer will not have the incentive to exercise his right, which is to “force” me to purchase 100 shares of MSFT from him. He has absolutely no incentive to sell 100 shares of MSFT at a price of $200/share when the price is above that level.

The put option will expire worthless and I get to keep my full premium of $1,240 and my “cash secured deposit” of $18,760 will be freed up to be redeployed in other trades.

I previously calculated my annualized ROI for this trade to be 12% which is a fairly decent return when compared to the average return of the stock market (7-8%)

Scenario 2: Share price of MSFT is under $200 at expiration

 Let’s say that in 6-month, when this option is about to expire, the share price of MSFT is below $200, say at $195.

The buyer of the put option will now have the incentive to exercise his right to sell 100 shares of MSFT to me at a price of $200 when the current market price is $195. Note that by executing his right, he will profit $5 from selling at $200 and buying at $195.

However, note that he has originally paid $12.40/share to me. So, his breakeven level is actually $187.60/share. The fact that MSFT is at $195/share on expiration means that he is actually making losses overall.

I, on the other hand, am happy to purchase MSFT at $200/share and my breakeven level is in fact at (200-12.40) = $187.60. For 100 shares, my net cost is thus $18,760 in total.

I have bought a great company at a great price, one which has been consistently paying a higher dividend amount every year for the past decade.

Sell Puts on Quality + Value counters for trading purpose

The second strategy that I deploy consistently is to sell puts for trading purposes. Unlike the first strategy which is to acquire good companies at a discount with a long-term horizon in mind, I have no intention of acquiring these companies which I sell puts on in the second strategy.

The goal of the second strategy is to consistently generate 15-30% annualized returns from a “trading” perspective.

There are certain key differences between both these 2 strategies.

Strategy 1: Sell puts on quality counters that are not necessarily exhibiting value characteristics but with every intention to buy these counters at the strike price which the put option was sold at. The Days to Expiration (DTE) for selling the put options might between 3-6 months horizon.

Strategy 2: No intention to purchase these counters as long-term holdings. The key purpose is to trade these counters through put options selling. In addition to identifying quality stock counters, we will also require an element of under-valuation (stock is not over-priced). The DTE for selling the put options are typically 1-2 months horizon.

When I execute put selling using Strategy 2, there is absolutely no “safety net” in place. If things go south, there is no excuse to take ownership of the physical stocks and turn a short-term trade into a long-term investment.

Instead, what I do is to follow my 7-steps trade rescue process which ensures that I am able to turn a “money-losing” trade into one which is moderately positive at the end of the day. Even if that particular trade results in an ROI of 0%, that result is significantly better than incurring a massive loss.

Given the “higher risk nature” of Strategy 2 as there is no longer a safety net in place (to take ownership of the stock), I only select stocks that fulfill certain quality and value criteria. This ensures that I am not selling puts on an overvalued stock in the very first place, regardless of how highly regarded that counter might be.

Combining quality + value criteria greatly reduces the probability of my sell puts trades going south substantially.

Strategy 2 is most ideal for stocks that are “boring” in nature and not one where you execute when you are extremely bullish on the counter. Going long on a call option will be the better “option” for the latter.

Bonus Strategy: Selling ATM LEAPS Put Option

This bonus strategy can be executed as an alternative to Strategy 1.

“LEAPS” stands for long-term equity anticipation securities. These are options that have an expiration date that is more than 12 months away.

The premiums for this type of option will be relatively high due to their relatively long contract period. In other words, these options have a high time value component.

Notice that I am selling ATM Put Options. ATM options are options that have the greatest amount of time value (when compared across the same DTE)

As a seller of options, you wish to maximize the amount of time value sold. ATM options are often the most “lucrative” options to sell. However, the key downside is that there is no “Margin of Safety”.

This bonus strategy should be executed during periods of high volatility, which translates to high options premiums and on stocks that you absolutely wish to own. By selling ATM LEAPS Puts on stocks you wish to own during a period of high volatility, you are essentially “locking” in the high premiums for the entire contract duration. If instead, you keep selling short-term options, volatility may decrease during the rest of the year.

For example, during the March/Apr COVID-19 driven sell-down, volatility is extremely high and one can “lock-in” that high volatility by selling a 1-year ATM Put option contract on a stock that you wish to own. If instead one chooses to sell a 2-months ATM Put option contract, he only gets to “lock-in” the high premium for that 2-months horizon. Subsequently with volatility collapsing, selling puts on the same stock will likely not generate the same level of premiums thereafter.  

Conclusion

Selling put options is one of the most flexible and powerful tools that one should have as part of his/her investing arsenal for buying stocks at a discount or generating consistent short-term income.

Rather than waiting to buy shares only at your target entry price (which might never happen), why not get paid during the period as you wait for your lower target entry price to be met? This is an ideal strategy for value investors who always wish to acquire a counter with a good MOS.

For those who wish to generate a consistent stream of “passive” income, one can also engage in put option selling on quality stocks that are undervalued. The big question, however, is accurately identifying these high quality, undervalued stocks consistently.

Overall, put selling is a strategy that allows one to make money 3 ways. The price goes up, the price stays flat and the price dips slightly.

While it is not the perfect tactic for a strong bull market like what we are currently witnessing where the FOMO level is extremely high, it is a good strategy if one is satisfied with generating a “conservative” return of 15-30% consistently.

For those who are interested to find out more about how you can trade options effectively and how you can generate a consistent stream of passive income every month, do join me in this FREE 2 hours Options Training Session where I will share with you more about the flexibility of using options and how they can be a useful tool in your trading arsenal.

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Disclosure: The accuracy of the material found in this article cannot be guaranteed. Past performance is not an assurance of future results. This article is not to be construed as a recommendation to Buy or Sell any shares or derivative products and is solely for reference only.