Which Stocks Should we Sell Puts On?

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.

treasure_map
Finding good stocks can be tricky

 

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.

Cheep cheep cheep
Cheep cheep cheep

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:

Data from "What Works On Wall Street" 4th edition.
Data from “What Works On Wall Street” 4th edition.

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?

7 Reasons to Sell Puts on Stable Dividend-Paying Stocks

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.