Right now I think Target shows great value for put sellers. Here’s why:
– The company currently yields nearly 3%. Even in the depths of 2008 and 2009 the maximum yield that was ever reached was a little over 2%. This is being achieved on a payout ratio of only 40%.
– The company has been increasing its dividend every year for far longer than I have been alive. That’s a long time.
– Insurance policies will cover much of the cost of the lawsuits related to the data breach. Lawsuits should soften the blow by around $150 million, with the total cost coming to around $250 million (assuming the breach is similar to the 2007 TJ Maxx breach).
– The company is currently trading on an EV/EBITDA of 7.2. On a P/E basis the company is cheaper than TJX, Costco, and Ross stores.
Yes, I get that they are having difficulty in Canada, that it’s facing stiff online competition, and that recent earnings and forecasts have been disappointing, but the value proposition of being assigned the stock at $50 to $55 is compelling. With the current volatility you’re able to pick up some tasty premium too. Here’s a mix of buy/sell articles.
This is the blueprint I use to find the stocks I can sell puts (or covered calls) on. It’s pretty simple – we’re essentially looking for good stocks that are trading cheaply and have some downside protection.
We have 3 basic steps for finding good stocks on which we can sell puts. We need to:
1) Find good stocks
2) …that are trading cheaply
3) …and then enter the trade at the right time.
So let’s take a look at how to use a free screener to find these stocks.
1) Finding good stocks to sell puts on
A good stock for a dividend value investor is a company with a significant competitive advantage (often called an “economic moat”) with a consistent cash flow to support a stable, growing dividend.
One of the easiest places to find a starting list of suitable stocks is the Dividend Aristocrats list. This is a diverse list of over 50 highly liquid, blue-chip stocks that have followed a policy of consistently increasing dividends every year for at least 25 years. You’ve probably heard of many of these companies – like McDonalds, Walmart, Coca-Cola, and Proctor & Gamble. If this list is not large enough, you can go into the Dividend Achievers list, which has similar requirements except that dividends only need to have been increasing for the last 10 years.
Of course, the best way is to get someone smarter than you to do the work first, which is why I also like to look at Warren Buffett’s top holdings, which is disclosed on a quarterly basis in the company’s 13-F filings. I generally use the StockRover.com stock screener which has Warren Buffett’s top 25 holdings pre-loaded.
These three lists will generally give me a universe of nearly 200 stocks, the majority of which a fairly high quality.
To make the list even higher quality, I use my stock screener (StockRover.com) to filter out any stock on the list that has a dividend yield of under 2%, or has a payout ratio above 70%. The payout ratio is how much of a company’s earnings is paid out as dividends. If this ratio is too high, then any decrease to the earnings in future will likely translate into reduced dividends. We want stable, growing dividends, so we prefer payout ratios under 70%.
These companies are leaders in their field, and likely have been for many years. If you want to filter the list further I would recommend screening by free cash flow (FCF) to sales. Free cash flow is the cash that is left over after the company has paid its bills and made any investments. Companies that can generate 10 cents of free cash or more on each dollar of sales (i.e. have a FCF/S ratio of over 10%) likely have a strong competitive advantage. Be aware though, that this high standard will make it very hard for some industries to make it through the filter (particularly retail companies).
2) Filtering for cheapness
Screening for cheap companies is essentially about working out what you are paying for an asset and then comparing this with what you are getting in return. This is why metrics for valuations of companies are often ratios of some form of PRICE divided by some form of RETURN.
The most basic valuation metric of this kind is the price to earnings (P/E) ratio. You are paying a certain price for a stock, and you are getting some earnings in return. Ideally the P/E ratio is low – i.e. you a paying a low price and getting significant earnings in return.
Alternatively you can use a price to book (P/B) ratio as a measure of cheapness. Again, here you a paying a certain price for an asset, but instead of using earnings as your return, you are using the book value of the company (what the company would be worth if it liquidated itself) as your measure of what you are getting for buying the stock.
There are a number of alternatives we can use for the PRICE part of the ratio, and a number of alternatives we can use for the RETURN part of the ratio, but the key is that they all measure the same kind of thing – the CHEAPNESS of the stock you are buying. The following chart shows the average annual performance of the cheapest 10% and most expensive 10% of large US stocks according to a number of different measures of “cheapness” between 1964 and 2009:
A gradual consensus is emerging that the best price identifier of cheap stocks is EV/EBITDA ratio. Interested readers should read this post at Greenbackd, but the basic idea behind it is that the price measure of enterprise value (EV) takes into account a company’s leverage, while the returns measure of EBITDA (earnings before interest, taxes, depreciation, and amortization) is less easily manipulated by companies compared to other forms of earnings.
However, what the above table clearly shows is that almost all value metrics work to some degree. As a result, I recommend using whatever is easiest to calculate in your own screener. StockRover is capable of ranking stocks by EV/EBITDA, which is great, but this unfortunately ignores the fact that we really should be comparing these ratios only within industries. StockRover can also rank stocks by P/E decile within their industry.
As a rule of thumb, I would consider a stock to pass the cheapness test if the EV/EBITDA ratio was under 15, or if the company ranked in the top 3 cheapest deciles of P/E within each industry. Using a stock screener, you can screen for these companies very easily.
3) Screening for the correct entry
We already have some downside protection by virtue of the fact that we have a list of good, dividend-paying stocks that are already cheap. These are stocks that we would like to own because their value will likely increase over the medium to long term. However, in the short term the stock may easily fall due to technical factors. Ideally, we would like to sell puts on a stock that has had (or is having) a pullback within the context of a longer term uptrend. This allows us to sell puts for a higher price (as stock volatility has increased), towards the lower end of the stock’s historical range, with greater upside for us in case we are assigned and the longer term uptrend continues.
To identify a stock that may fit these criteria I screen for an RSI below 50 (i.e. oversold to some degree), but above the 50 day simple moving average. I will also look at the chart of every stock that is in my filtered list to see if there is a defined resistance point, below which I could sell a put.
… and some final considerations
The last thing to do before entering a trade is to use your discretion to consider your total downside risk. It can be easy to get caught in a large downswing with little protection when you are sell puts. I like to look at previous drawdowns in the stock’s price (particularly 2008-2009) and consider whether my portfolio could handle a drawdown of that magnitude again. I like to look at when the company is reporting earnings, and when the next ex-dividend date is. Both of these should be available through your broker. Most importantly you need to continually ask yourself – DO I WANT TO OWN THIS STOCK?
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.
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!”