Sell Puts to Put the Odds in Your Favor (2002)

Sell Puts to Put the Odds in Your Favor

Mark Vakkur, MD

Introduction

How would you like a guaranteed way to buy a stock at a discount to its current price? Sound too good to be true? It isn't. Selling puts, a little used and even less understood strategy, enhances returns, reduces risk, and lets you buy stock at a discount. If you are comfortable with the idea of selling a covered call, then you are already sold on the virtues of selling naked puts, whether you realize it or not.

A Neglected Strategy

Most investors, especially risk-averse investors, are familiar with the strategy of selling covered calls, that is selling calls against a stock they already own. This strategy creates income and lowers cost basis (therefore, lowering the breakeven price and risk). Suggest to these investors that they instead sell naked puts and most would react in horror.

They shouldn't. The two strategies are essentially the same.

What most investors and traders may not understand is that selling a naked put is mathematically identical to selling a covered call. Because the naked put has lower margin requirements and potentially requires only one commission (if the put expires worthless), in most cases a would-be covered call writer would be better off selling puts.

Yet selling puts is not nearly as popular a strategy as selling covered calls. Why? The cynical answer is that the brokerage industry loves to collect 2-4 commissions (instead of 1-2 for the naked put). But the more straightforward answer is simple lack of knowledge.

Understanding the naked put sale requires that you wrap your mind around a double negative. To do that, you must understand some basic terminology.

Basic Terms

A call option is a contract that gives the buyer the right, but not the obligation, to buy 100 shares of a stock at a certain price (the strike price) on or before a certain date (the expiration date). For example, a Microsoft July 70 call gives you the right to buy 100 shares of Microsoft on or before the third Friday in July. If Microsoft closes at or BELOW 70 by expiration, the call expires worthless.

A put option gives the purchaser the right, but not the obligation, to sell 100 shares of a given stock at a given price (the strike price) on or before a certain date (the expiration date). A Microsoft July 70 put gives the purchaser the right to sell 100 shares of Microsoft at 70 on or before the third Friday of July. If Microsoft closes at 70 or ABOVE, the option expires worthless.

The price of an option consists of two parts. The first part is the intrinsic value, the value of an option if expiration were to occur today. If Microsoft were trading at 65, the 70 put would have an intrinsic value of 5 (70 minus 65). If Microsoft were at 75, the intrinsic value of a 70 call option would be 5 (75 minus 70) since the holder of the call option could buy Microsoft at $70 per share, then turn around and sell it immediately at $75, the prevailing market price.

So what would be the intrinsic value of a 70 put option if Microsoft traded at 75? The answer is zero because an intrinsic value can never be negative. If a stock is trading below a put's strike price, the option will have no intrinsic value, since no one would pay for the right to sell a stock for a price lower than the current price. The reason the option's intrinsic value never goes negative is because the holder of the put does not have the obligation, only the right, to sell the stock.

The seller of the put (call), on the other hand, has the obligation to buy (sell) the stock if the stock trades below (above) the strike price of the option at expiration (or before, in the case of early assignment).

If this is confusing, remember this simple table:

Type of option	BUYING creates the:	SELLING creates the:	If at expiration the stock trades:
Call	RIGHT to buy	OBLIGATION to sell	ABOVE the strike price
Put	RIGHT to sell	OBLIGATION to buy	BELOW the strike price

The second component of an option's price is known as time value. This can be thought of as an uncertainty factor, the dollar amount that the seller of a put demands to sell you the right to sell a stock or index. Obviously, the greater the volatility of the stock or index, the greater the time value, all things being equal. Options for Cisco will be more expensive than options for Chevron.

Of course, all things are never equal, which is what makes options so challenging. Interest rates, dividends, and pending news or rumors can all affect the price of an option.

Adding the intrinsic value to time value gives you the total option price, often referred to as premium. For example, a Microsoft July 70 put with 3 weeks to go until expiration may sell for 3 with Microsoft at 69. This represents $1 of intrinsic value (70 minus 69) plus $2 of time value (the remainder). As expiration nears, the time value will waste away, decaying most rapidly in the final weeks before expiration.

There are very few guarantees in the market, but this is one: by the time of expiration, the time value of an option will be zero. This does not mean you are guaranteed a profit, only that you will get to keep the portion of the option premium that is made up of time value.

If you think about it, that is a pretty powerful statement. You will be guaranteed to collect the time premium (net commissions) in return for the risk that the option's intrinsic value at expiration will exceed the time premium and intrinsic value at the time you sold the option. So what is the downside?

The downside is that in exchange for the time premium, you must assume the risk that the underlying may move against you. However, for put selling, this dollar risk is LESS than if you bought the underlying, as will be illustrated below.

There is one wrinkle of selling puts - the seller may be forced to buy the stock. This is called assignment, and only occurs if the option is in-the-money. However, if you are financially and psychologically prepared to buy the stock anyway (which you should be if you are selling puts), this is hardly a disaster. Rather, you have effectively purchased the stock at a discount to the price you would have paid had you bought it outright (instead of selling the put).

An Example

Consider the Microsoft option above. Let's say Microsoft closes at 61 on expiration day (and furthermore that you have not been assigned (forced to buy) the stock prior to expiration). The 70 put has an intrinsic value of 9 (70 - 61). Since the time value must be zero at expiration, 9 is the most the option can be worth. If you sold the option for 3 when Microsoft was at 69, then you lost money (although you kept the time premium of $2). So you keep the time value (+$2), but lose the change in intrinsic value (-$9), for a net loss of -$7 before commissions. (In reality, the option is exercised - the Monday after option expiration, you will own 100 shares of MSFT purchased at $70 a share. You could immediately liquidate the position, selling Microsoft @ $61, losing $9 a share on the trade, but keeping the $2 premium, for a net loss of $7. As you can see, the effect is the same.)

So what's the big deal, you ask? The big deal is that if you do this an infinite number of times and Microsoft does not go bankrupt, you are much better off than an outright stock purchaser. To illustrate, had you bought Microsoft at $69, you would now be looking at a $9 a share loss, since of course you didn't collect $2 in time value when you bought the shares outright.

You have probably heard admonishments against selling calls, where your risk is unlimited. However, selling naked puts, as long as you sell no more puts than you would be willing to purchase shares (e.g., sell 5 puts if you would be comfortable buying 500 shares), entails FINITE risk, LESS than that of a stockowner. Selling puts, if you use the guidelines in this article, is actually LESS risky than owning the underlying stock.

Consider the worst case above: the most you could lose selling a Microsoft 70 put for $3 when Microsoft is at $69 would be $6,700 (plus commissions) - and that would be only if Microsoft would go to zero by the third Friday of next month! Yes, it could happen, but even if Microsoft went bankrupt, it would likely take more than a month. The most you could lose if you bought the stock outright is $6,900, $200 more. However, if Microsoft goes nowhere, the put seller pockets a tidy $200 profit and can repeat the cycle next month. The stockholder, on the other hand, gets paid nothing for waiting. A table illustrates these outcomes:

	Put seller - sells 1 Microsoft 70 put for $3.	Stock purchaser - buys 100 shares of Microsoft @ $69.
Initial outlay:	Zero.	$6,900 plus commissions.
Initial credit:	$300 minus commissions.	Zero.
Interest earned (on uninvested cash):	$20 (@ 3.5% per annum x 1 month)	Zero.
Net anticipated cash flow:	$320 CREDIT minus commissions	$6,900 DEBIT minus commissions.

Since Microsoft can only do one of three things (go up, go down, or end flat), another table illustrates the possible outcomes:

Microsoft price at expiration:	Put seller:	Stock purchaser:	Put selling advantage (disadvantage):
75 +$5	+$320 profit	$600 profit	($280)
69 - unchanged	+$220 profit net commissions (will be forced to buy Microsoft at $70 a share, creating a $100 loss, offset against the $320 collected)	$0 profit/loss	+$220
64 -$5	-$280 loss net commissions (will be forced to buy Microsoft at $70 a share, creating a $600 loss, offset against the $320 collected)	-$500 loss	+$220

You could create a table showing all possible prices of Microsoft and profit/loss outcomes. I highly encourage this if you really want to understand options. For any price of Microsoft at or below $72, you would be better off selling the put (versus buying the stock). (See Figure One:

Figure One: Profit-Loss graph for buying 100 shares of Microsoft @ $69 versus selling a $70 put for $3.

As Figure One illustrates, you would only be better off buying the stock if the stock soared above $72. The dollar advantage of the put seller at prices below $72 equals the time premium collected (the total premium minus the intrinsic value when the option was sold), in this case $2 ($3 - $1). The $20 represents the effect of having $7,000 of cash at work in bonds or Treasury bills. One could do much better than this by collateralizing the investment in corporate bonds or even Treasury bonds with longer maturities.

Bottom line: the RISK of selling puts is always less than the risk of buying an equivalent number of shares of the stock; however, in exchange for this decreased risk, you are capping your maximum profit. Sound familiar? It should - this is in essence a covered call!

These returns may seem rather tame until you consider a few basic facts:

• the probability of an asset closing unchanged or slightly changed in a given month is much greater than the probability of it moving much higher;
• therefore, you exchange a low probability high profit for a high probability low profit; selling puts infinitely puts you ahead with a smoother equity curve of the outright stock purchaser.
• If you collect only 1.5% of time premium a month, you will be adding 20% gross annual returns to your portfolio. If you collect 3% a month (the approximate value of a 25% at-the-money call option expiring in a month), you will gross 42.6% a year! Remember: this is your return if the stock goes nowhere. If it goes up, you do even better.

Another Example

The easiest way to illustrate the power of selling puts is to imagine a simple portfolio consisting of $100,000 of uninvested cash. You want to put your money to work buying XYZ Technology. For fundamental and technical reasons, you are convinced that this is a stock to own. You are comfortable assuming the risk of ownership of this stock in exchange for the prospect of the stock rising substantially in price.

Let's say that XYZ is currently at 100. If you wanted to buy $100,000 of stock (ignoring commissions for simplicity), you would buy 1,000 shares. Then you would wait.

Does this position cost you anything? Yes. If the stock goes nowhere, you forfeit the interest you would have earned on the uninvested cash. You also assume the risk that XYZ could decline significantly. Since theoretically XYZ could do one of three things - go down, up, or sideways, you will only make money if one of those three things happens (the stock goes up).

Let's compare this to selling a put. Assume that in late June you do a little research and determine that the bid price for XYZ July options are currently as follows (bid x ask):

Strike price:	Calls	Puts
110	.25 x .35	11 x 11.5
105	1.75 x 2.00	6.5 x 6.75
100	3.00 x 3.10	1.75 x 1.85
95	6.10 x 6.25	0.45 x 0.55
90	11.10 x 11.70	0.20 x 0.30

Let's say that instead of buying the stock or its calls, you sell a put. Which put? It depends on how bullish you are on the stock and how much you want to own it.

Wait a second, you are probably thinking. Who said anything about owning the stock? You just want to sell the put, right?

One of the best things that can happen to you if you sell a put (besides the put expiring worthless) is being assigned the stock. Why? Because assignment means that you keep the time premium, and buy the stock at a price that is a discount to the price prevailing at the time you sold the put.

So let's go through a specific example. Let's say you sell 10 contracts of the 105 put. You would place an order with your broker to "sell to open 10 XYZ July 105 puts". You could do this at market or with limit orders, but in a liquid market you will get filled very close to the last printed trade.

So here's what happens: in a few seconds, you will be short the 105 puts, and $7,350 (minus commissions) will hit your account. That's right - you will get paid to wait! No matter what happens to the stock, you can keep that money.

However, since you have sold the right to sell the stock at 105, you now have the OBLIGATION to BUY the stock at 105.

So let's say, with XYZ at 100, your broker calls to inform you that you have been assigned XYZ, meaning you have to buy it. Since you have to buy it at 105, you immediately are showing a $5 per share loss in your position. However, since you collected $6.50 per share, you are ahead $1.50.

Big deal, you say. Well, consider that $1.50 is 1.50% of 100, XYZ's market price. Consider that you made this 1.5% in at most one month (less if you are assigned before expiration). Annualized, this is 20%. Remember, the stock didn't budge, but you made 20% annualized.

Why annualize this return? After all, you are only able to do this once, right?

No, because once you own the stock you could either sell it immediately and start another cycle or you could turn around and sell calls against your position. If you'll notice, owning the stock and selling the 105 call gives you the same profit-loss outlook (plus or minus a few dollars) as selling the 105 put. This is because the two positions are essentially equal.

Generally, you will collect more in premium from selling a call as for selling an equivalent put. This reflects:

• the general bullish sentiment in the market (stocks tend to rise more often than they fall, and they can rise a theoretically infinite amount, whereas the most they can fall is 100%),
• the fact that a stockholder will collect a dividend (something a put seller won't).
• margin costs of buying the stock (or opportunity costs of otherwise invested cash) which a call purchaser would not incur, meaning a call buyer would be willing to pay more to avoid these costs.)

However, this lower premium collected is generally offset by the advantages of selling the put, namely that you will collect interest on your uninvested cash and pay only one commission to establish the position.

Some Put-Selling Guidelines:

1. Only sell puts on stocks you would want to own. Never sell a put just because it has a fat premium. Ask yourself: "If I had to buy the stock tomorrow, would I be happy owning it?" If the answer is no, do not sell the put.
2. Never sell so many puts that if you were assigned, you would not have enough buying power to purchase the stock. For example, if you have a $100,000 margin account, and you are uncomfortable being more than 100% exposed to equities, do not sell more puts than would require $100,000 to cover if assigned. To determine the dollar amount required to meet an assignment, simply multiply 100 times the strike price of each put contract sold. For example, if you were selling puts against a single stock trading at $100 a share, do not sell more than 10 at-the-money puts, 11 90 puts, or 12 80 puts, etc. You can never get into too much trouble if you follow this guideline. It is tempting, especially after few successful cycles of put selling, to sell more puts to boost income but if you are in effect using 300% or 400% leverage, you could get badly hurt. Put selling got a bad name after the crash of 1987 mainly because it was abused by speculators who wrote far out-of-the-money index puts representing much more money than they had an their accounts. They assumed the market would never fall below the strike price of the puts sold. They were wrong. When the market crashed, they were forced to borrow large sums of money to meet margin calls. Never assume a put is so far out-of-the-money that you won't get assigned!
3. Sell puts expiring in 1 to 3 months. The risk of selling close-to-expiration puts is lower for every dollar of premium received. Selling options as close to expiration as possible exploits the period of maximum premium wasting and creates the highest annualized returns.
4. Annualize option time premium collected. For example, if you sell a 95 put on XYZ Technologies trading at 100 for 6.50, you collected $1.50 of time premium, which works out to 20% annualized. More conservatively, convert option time premium to time premium per month (to compare closer-to-option expirations with those expiring later). The time premium is usually fattest for at-the-money options, and diminishes as you go further in- or out-of-the-money.
5. Demand at least 1.5% time value per month for any option sold. To express a put price as a percentage, divide by the strike price of the option sold. It is not uncommon to be able to pocket 4-5% a month for slightly out-of-the-money put options on volatile stocks. There seems to be some inefficiency in the pricing of lower-priced stocks, e.g., those trading below $20 a share, so look to these issues for great deals. (However, remember guideline #1: never sell an option just because the premium is high!)
6. If you are very bullish on the stock, and really want to own it, sell deeply in-the-money puts. This gives you greater risk, but more opportunity to participate in the upside.
7. If you are more cautious and just want to collect time premium, sell out-of-the-money puts. You will collect less premium initially, but will have more downside protection.
8. Consider selling a put after a stock that you think is good long-term buy just suffered a dramatic decline. Put premiums will often soar to ridiculous levels, allowing you to pocket the premium or buy the stock at a significant discount. Selling puts at these points requires tremendous courage but is safer then buying the stock outright since the premium collected gives you a buffer. This principle can be generalized to indexes; put sellers did very well if they stepped up and sold following most recent market dramatic declines.
9. For best results, repeat the cycle every month. A mechanically-followed mediocre strategy is almost always superior to an intermittently-followed brilliant one. To achieve anywhere close to the annualized returns possible from put selling, you must participate on as regular a basis as your risk tolerance and buying power will allow.
10. If assigned, consider immediately turning around and selling a call against your newly purchased stock. Keep the wasting power of options working in your favor!

Summary:

Selling a naked put is an outstanding, low risk way to increase income and perhaps acquire a stock at a discount. Put selling is especially profitable following a severe market decline, when put premiums can soar. You are trading a potentially unlimited but low probability gain for a capped but high probability gain. Repeated an infinite number of times (every month), you will often end up ahead by selling puts versus buying the underlying. Even if your bullish analysis is wrong and the stock declines, you will still be better off than the outright purchaser of the stock, since your net price (the strike price minus the premium collected) will be lower than the price of the stock on the day you sold the option. You can botch your stock analysis, be less than perfect with your timing, and still end up ahead. You are selling a wasting asset. Over time, the odds are in your favor.