I sell puts options on high quality, value companies that pay a stable dividend. I’ve found that this is the put-selling strategy that maximizes risk adjusted returns and conserves capital. Selling naked or cash-secured puts is a great strategy in itself, but selling them on dividend paying blue chip stocks is even better. Here are the top reasons why this is one of my favorite strategies (file this under boring but important):
1) Recent Paper Shows “Significant Net Benefit From Selling Puts”
According to a 2007 paper by James Doran and Andy Fodor, there can be “significant positive net benefit from selling puts.” The researchers examined the benefits and costs of 12 basic strategies to increase return on a group of stocks using the associated options. They concluded that not a single long options strategy outperformed the market. Conversely, they concluded that selling puts had a significant positive benefit, and that there could be some benefit from selling calls when the leverage used was high enough to overcome transaction costs.
2) Short Term Naked Options Are “Highly Profitable”
In a 2006 revision of a past paper titled “Is There Money to be Made Investing in Options? A Historical Perspective”, Doran and Fodor also found that over a long period of time (1970 – 2004) short-term naked option strategies were highly profitable, enhancing risk adjusted returns. They found that selling put options exploited the “crashophobia” of other investors. They also found that selling short-term at-the-money or out-of-the-money call options outperformed on a risk adjusted basis (even though it limited upside gain)
3) You Get a Higher Premium From Selling Options on Value Stocks
Blue chip stocks tend to be more value oriented, rather than growth. In a paper titled “Systematic Variance Risk and Firm Characteristics in the Equity Options Market” Vadim di Pietro and Gregory Vainberg found that options on value stocks are more expensive than those on growth stocks. This makes selling options on value stocks more profitable. This is likely because value investors are more risk averse than growth investors, so as a result they are more likely to try to buy puts on their positions.
4) Option Sellers Have Better Returns When Using Low Beta and Low P/B Stocks
Another paper in 2008, titled “Implied and Realised Volatility in the Cross-Section of Equity Options” found that option sellers had a greater net return when focusing on low beta stocks with low P/B ratios. Blue-chip value stocks tend to have both low market betas and low P/B ratios, making them a good choice.
5) Lower Commissions for Same Position Size in Higher Priced Stocks
As a general rule, blue chip stocks generally have a higher nominal share price than small cap stocks. This means that for the equivalent cash-secured position size, we will pay less in commissions for a higher priced stock than a lower priced stock. For example, if we had a $10,000 account, we could sell one put on a stock at $100, paying commission of under a dollar OR we could sell 10 puts on a stock at $10, paying around ten dollars in commission. Keeping commissions low means we get to keep more of our profits.
6) Large Cap Value Stocks Have Narrower Spreads, Better Liquidity, Greater Choice of Expiries
Large cap value stocks have narrow bid-ask spreads, plenty of liquidity (in case you need to exit a position in a fast market), and have more option expiry dates to trade. This means that trading blue chips significantly reduces your slippage costs and gives you more flexibility in timing your trades.
7) Stable Dividend Payers Have a Natural “Value Floor” in Their Price
Because we are selling puts on stable dividend players (picked from the list of Dividend Aristocrats), there is a natural floor in the price of the stock. For blue chip dividend payers you are getting paid to simply hold the stock, and the more the stock falls, the greater the dividend yield (and the more attractive the stock) will be. For a high P/E or growth company like Tesla, there is no natural floor – the stock price is based on expectations of cash flow many, many years in the future. Our blue chips have an exceptionally long record of rewarding their owners with steady and increasing cash payments.
And those are the reasons why you shouldn’t just blindly sell puts on any old stock. Most importantly, you need to either be happy to own the stock you are selling a put on OR have an exit strategy before assignment. In the next post I’ll discuss why a COUNTERTREND strategy is particularly appropriate for the kind of stocks that we sell puts on.