There’s this great episode of The Simpsons where Homer discovers that the reason he’s not that smart is that he’s had a crayon lodged in his brain since he was six, which reduces his IQ to 55. He goes to the doctor and gets it taken out, and discovers that without the crayon in his brain, he’s actually a genius.
Unfortunately his newfound intelligence alienates him from his friends and family. So he decides to get Moe the barman to stick the crayon back up his nose and into his brain so he can go back to being the stupid but loveable guy he was before. As Moe pushes the crayon back into his brain, Homer gets progressively less smart. Moe keeps pushing it deeper until they realise he’s back to his old self when he announces “Extended warranty? How can I lose?”
It’s pretty much universally known that buying an extended warranty on most things is not worth it, and consumer advocate groups recommend against it. Now of course, with some things buying insurance is a great idea, but it depends on the product and the person.
It’s the same in the stock market – there are some people who really need insurance so that when the stock market goes down, they won’t lose all their money. These people, like people who buy extended warranties, are almost always overpaying for peace of mind. The people who need this market insurance are hedge funds or companies who are judged on their performance on a month-to-month basis. Individuals with a long term outlook will generally not benefit from market insurance.
This means that we are in a unique position – we are able to sell insurance to these folks. We get to collect insurance premium from them. And the more the market falls, the more scared they are, so the more we can charge for this market insurance. We can use this strategy to effectively get paid to buy stocks from these people at a lower price than the current market price.
This strategy of collecting insurance premium is known as writing “cash-secured puts”. It’s called “cash-secured” because you need to have cash in your brokerage account in the case that you have to “pay out” on the insurance you sold. The great part of this is that you are getting paid to buy good stocks at lower prices than you can get in the market right now. Let’s take a quick look at the mechanics of a cash-secured put below.
Let’s say you’ve identified McDonald’s (MCD) as a good stock you’d like to own. As I’m writing this, the stock is trading at about $99. It’s had a bit of a run-up, so ideally we’d like to own it at a lower price. If it fell to $97, then it would probably start to look like a good buying opportunity.
In this case we should sell puts on the stock with a strike price of $97. For selling this put option (which will expire in two weeks from today) we will receive $62. (the quote is 0.62, but remember that options generally have a x100 multiplier, meaning that each option is to buy or sell 100 shares, not just one). This is essentially the “insurance premium” we are getting paid.
Now what happens? Well, one of two things can happen:
MCD stays above the strike price ($97). In this case nothing really happens. Our net profit on the trade is the $62 we got from selling the put, that’s it. It doesn’t sound like much but that’s an annualised return of nearly 17% – pretty darn good, I’d say.
MCD dips below the strike price ($97). In this case, we may be obliged to purchase 100 shares of the stock for the price of $97 per share (which works out to be a total cost of $9,700, because each option is for 100 shares). This is why it’s called a “cash-secured” put – we needed to have that cash in our account, just in case MCD fell and we had to buy it. So what does this mean? It means you now own a high quality, dividend-paying company at a LOWER price than what you would have paid for it two weeks ago, AND you get to keep the $62 you got from selling the put in the first place.
Now what? Well, now you can congratulate yourself on buying a good company at a lower price that you would have done, OR you can turn around and start selling a covered call on it.
What are the risks of selling puts?
The only real risk of this strategy is that the company you sell a put on falls dramatically. This is why the strategy is just like collecting an insurance premium. In the example above, if McDonald’s had fallen to, say, $60 in those two weeks, you would have had to buy the shares for $9,700 when they’re only now actually worth $6,000. The person who had bought the put option from you would have saved themselves a lot of money by “insuring” their MCD position with that put option. So how do we reduce this risk of this?
- We only sell put options on stocks we want to own. You need to be happy if you end up owning the stock because of the put you sold.
- We only sell puts on high quality, dividend paying stocks with a low “beta”. These are boring, un-sexy stocks that your grandfather would own. These are stocks that have a history of increasing their dividends, and are less likely to collapse in value suddenly. McDonald’s would be considered one of these kinds of companies – over 2008, when the stock market was collapsing around it, shares of MCD actually rose from around $57 up to around $61. You shouldn’t be selling puts on momentum companies that can reverse gears in an instant (e.g. Tesla, or Netflix).
- We only sell puts on these boring companies when they look like compelling value – they might be trading towards the low end of their P/E ratio, or at a discount to their peers, or they might be heavily oversold. Either way, the balance of probabilities is that over the long term they might increase in value.
- We sell puts over a number of different companies in different industries. If you only sell puts on BP (BP), ConocoPhillips (COP), and Exxon Mobil (XOM) then you are vulnerable to a single risk factor – oil prices.
- We also spread our risk out over a number of option maturities.
So there you have it. Selling puts on a stock you like is similar to selling insurance for those stocks. In the rare case that you might have to “pay out” on this insurance and buy the stock from whomever purchased the insurance, you get to own a good stock at a lower price that it previously was at. Be patient and cautious, and only sell puts on stocks you’d like to own, or you too will end up slapping your head and saying “D’oh!”