By Paul Price
Every investment technique can be useful in the right circumstance. Understanding how to use short options adds a valuable tool to your skill sets. If your portfolio includes options, the way you structure it may be even more important to your results as stock selection.
Using options magnifies the effects of stock movements. The higher volatility relates to the smaller principal amounts involved in option trades versus outright purchase of shares. This quality, known as leverage, is a wonderful thing when you are correct in both your assessment of future price movement and correct in your timing.
Leverage can be painful, however, if you are wrong on direction or timing. Employing proper strategy allows you to establish positions you can live with while waiting for the ultimate results to play out.
Following two simple rules regarding put selling doesn’t guarantee profits, but does allow you to hold on to the position long enough to see if the reasoning behind the trade was valid.
Rule #1 applies to solid underlying stock selection based on fundamentals. If you can’t outline a well thought-out case for a higher 6 – 18 month target price, don’t sell the puts.
Rule #2 is crucial. Never sell more puts than you could comfortably afford to have exercised. The dollar amount needed in an ‘if put’ scenario should be reasonable in relation to the size of your typical equity position size.
If your normal size buy equals about $10,000 worth of shares, limit your put writing to 1 contract on a $100 strike (1 contract represents 100 shares), 2 on a $50 name, 4 on a $25 issue, or 10 contracts on a stock priced at $10 etc. Everyone’s portfolio size is not the same. Adjust the number of puts you sell to be in accordance with your portfolio size.
Fight the urge to trade too large a quantity of options. Many people violate this principle by looking only at the premium received, rather than the ‘if put’ commitment in dollars.
Here is a real-life example of a ‘stock plus puts’ sale I made for my personal account just weeks ago.
Cognizant Tech (CTSH) has a stellar growth record yet had pulled back to relatively cheap levels in May this year. I bought 200 shares outright for $63.02 on May 17, 2013, while simultaneously selling three contracts of the Jan. 2014, $65 strike price puts. My account was credited with a $7.50 per share premium for those puts.
On May 28, 2013, I went back and sold 2 additional CTSH Jan. 2014, $70 put contracts. They represented an additional, bullish bet on the future movement of Cognizant Tech. For simplicity, those extra contracts will not be part of the discussion that follows.
Below is a chart I constructed to demonstrate CTSH’s cheap relative valuation just prior to the time of my trades. I was lucky enough to catch a weaker opening the next morning. That allowed for buying shares a bit lower than the previous day’s close. It also made for excellent put premium.
It cost $12,606 including commissions for the 200 share purchase at $63.02. The sale of the three $65 strike price put contracts brought in $2,247 in net cash.
The shares have no specific time commitment. The puts have an eight-month duration before their Jan. 18, 2014, expiration date. The worst-case scenario for those puts would force me to buy another 300 CTSH at a net price of $65.00 - $7.50 = $57.50 /share. That would require a cash outlay of $19,500, if exercised, less the $2,247 I collected from selling the puts.
In the best case (CTSH closing at $65 or better), I’ll be sitting on paper gains of at least $1.98 per share on the shares I owned outright. There is no upper limit on that profit. As of 4 PM on July 11, 2013 Cognizant was trading at $71.05.
In addition, I will have made $2,247 on the expired puts without needing to buy any additional shares.
The worst case scenario, in which CTSH closes less than $65 on expiration date, is not a negative because I believe the shares are worth more.
The break-even price of the 500 total shares would be $59.74. That is $3.28 per share below the trade inception price of $63.02. This gives me a 5.2% margin of safety.
Neither technique can be judged right or wrong, better or worse, until you know where the shares close on the option expiration date. Here’s a ‘cheat sheet’ to help you compare which does best under various final price points.
Option savvy traders have alternative ways to play the same bullish opinion on the identical underlying company. It is always good to have choices.
Disclosure: I executed the trades described above in my personal account. I am long CTSH shares and short CTSH puts.