Selling Puts on Value Companies
By Paul Price
Review and two more selling put ideas (see part 1 here). Updated Virtual Portfolios here.
Options are not just for speculation. Selling (writing) puts on stocks you’d like to own is an interesting way to enter stocks at cheaper prices. If the stock price is over the strike price, we keep the "premium" we sold the put for, and do not end up buying the stock.
Selling (“shorting”) a put is a bullish position. Our results will be best if the underlying shares go up or remain flat from their trade inception price. Once we’ve sold a put, there are only two outcomes that can occur at expiration.
- If the shares are above the option’s strike price, the puts will expire worthless.
- If the stock is below the strike price, we will be forced to buy 100 shares per contract (one contract = one put).
When puts expire worthless, the sellers of those options keep all premiums received and have no further obligations.
We would make our maximum potential profit, which equals 100% of the money received when we sold the put option.
Exercises of put options typically occur at or near expiration dates, but they can occur sooner. Timing is at the discretion of the option owner, not the seller.
Selling puts is similar to placing below-market limit orders to buy. In either case, we might, or might not, end up owning shares of the underlying stock. If the put is "put to us" – i.e. we are forced to buy 100 shares of stock per put – our entry price will be lower than had we bought the stock directly instead. In other words, if we buy the stock, we will get a cheaper price due to our selling the put – collecting money from the sale (the "premium").
Puts are often less actively traded than stocks. I always try to get a middle price between the bid -ask spread.
I also use expiration dates that bring in enough premium to justify the trade. The raw material we’re selling is ‘time.’ Selling even a full year costs nothing except the opportunity to move on quickly to the next trade because our money gets tied up.
Having a one-year time horizon brings in bigger initial premiums and lower break-even points than writing shorter expiration puts.
Here is the math on two short put positions that make sense to me right now.
If MOS rises by 1.1% or better and closes above $60 on Jan. 17, 2014:
- The put will expire worthless
- You will keep $750 per contract as pure profit
If MOS closes below $60 on Jan. 17, 2018:
- The put will be exercised
- You will be forced to buy 100 shares / contract
- You will need to lay out $6,000 /contract in cash
- Your net cost will be $52.50 /share or 11.5% below the trade inception price
If LH rises by 0.3% or better and closes above $87.50 on May 17, 2013:
- The put will expire worthless
- You will keep $400 per contract as pure profit
If LH closes below $87.50 on May 17, 2013:
- The put will be exercised
- You will be forced to buy 100 shares / contract
- You will need to lay out $8,750 /contract in cash
- Your net cost will be $83.50 /share or 4.3% below the trade inception price
In a worst case you will end up owing 100 shares of each stock at what I’d deem a bargain price. In the best case scenario both options will expire and we’ll keep the $1,150 (total) in premiums received without having to buy anything.
New Virtual Put Selling Portfolio
Disclosure: Long MOS shares, Long LH shares
Note about Puts
Selling (or “shorting”) a put is a bullish position because we are selling someone the right to make us BUY a stock at a certain price (strike price) on a certain date (expiration). The put buyer will only “put” the stock to us (make us buy the stock at the strike price) if it is trading lower than the strike price.
Put options are the opposite of “calls.” When we buy a put, we’re buying protection against the stock going down – paying someone for the right to sell our stock to them for a higher price. When we sell a put, we are selling someone the right to make us buy the stock. If the stock is above the strike price at expiration, the put will be worthless. The price of a put increases as the underlying stock drops in price.
SELLING a put lets us either buy a stock at a discount to where it is trading when we initiate the trade OR it lets us keep the money from selling the put. We risk being forced to buy the stock for MORE than it is trading for at expiration. A drop in the shares greater than the amount collected selling the put becomes a loss.
