Thursday, May 9, 2013

My mini-Berkshire strategy for selling insurance through puts and calls

I view myself as a mini Berkshire Hathaway. Every month, I get some cash flow that needs to be invested. My sources of cash flow include money I saved from my day job salary, dividends and some money from side hustles. I used to view my side hustle income as something that is similar to investing in newspapers, but lately the cashflow from it has been similar to what Buffett experienced for 20 years with the original textile mill. My investing portfolio portion is similar to the portfolios of securities that Berkshire owns. I view my salary income as businesses income, since I provide services to a large client, who is my employer.

These three sources of cashflow are exponentially increasing my dividend snowball, which is projected to exceed my expenses in five years. However, I have been missing the cost free insurance float, which Berkshire has leveraged for the past forty-fifty years. For the past four years I have tinkered with a strategy, that could essentially generate an additional cashflow for me to invest, by selling insurance. I went live with the strategy last month, and so far the results have been meeting my expectations.

The insurance I will be selling is mostly naked puts. You can read more about selling puts here and selling covered calls in previous articles I have written on the topic. With my strategy, I will be leveraging existing funds in one of my portfolios to sell naked puts. Before you start executing this strategy however, your broker needs to approve you for the highest level of option activity in a margin account. This could be a risky strategy, if you do not understand what you are getting into.

For my strategy, I plan on selling puts on S&P 500 ETF (SPY), which trade approximately 10 points below the current price and will expire within 4 – 6 weeks. I found that it would be easier to invest in an index ETF options because of high liquidity, elimination of specific stock risk and low bid/ask spreads. Please remember that these are approximations and not hard rules set in stone. I plan on making a trade once a month, although I keep my flexibility and not make trades depending on market conditions. I will exit options sold either if they expire worthless, I sell them or if I get assigned.

Some investors sell puts against stocks that they want to purchase, and this is a perfectly legitimate practice. For example, if McDonald’s (MCD) trades at $100/share, but I want to purchase it at $80, I could simply sell a put that expires in a few months. I can then collect the premium and if I get assigned I get a stock at a discount. If not, I collect the premium. The issue with this strategy is that that in a $60,000 - $120,000 portfolio, you are exposing yourself to too much individual security risk. In order to minimize that, I am focusing on the S&P 500 ETF (SPY).

I have designated approximately 25% of my account equity from one of my brokerage accounts as the portion that will be allocated to this strategy. My account is 100% invested in individual dividend stocks, and I am not adding any additional money to it as part of my strategy to protect myself against broker failures. As a result I am essentially playing with borrowed money.

Let’s assume that my account equity is $60,000. That means that I can sell puts worth up to $15,000. If SPY trades at $150 , I can sell one put contract for 100 shares, and immediately use the premium amount as I see fit. If SPY never falls below the strike price by the time it expires, I would have earned a premium and the liability involved with it will be terminated.

However, if the option falls in value after I sold it, and trades at a low price of say 10 -15 cents with more time to go till expiration, I would likely buy it back. I could then sell another option at a higher strike, or simply stay put.

The main risk with this strategy is if the market declines below the strike price, and stays there until option expiration date. The put price will increase dramatically, and by expiration date I will be assigned the underlying. However, using the example above, I would be essentially purchasing equities at a lower price than the cost at the time I entered into the options trade. I would essentially have to come up with $15,000 to purchase the underlying once it is assigned to me. In a margin account, I can take that 25% of equity and deploy it into the underlying on margin. I would have to pay margin interest to my broker for it, which could be expensive.

From there on, I have several options of what to do with the 100 shares of SPY for every naked put contract I have sold. I could either sell the shares in the market at a gain or loss, or I could sell covered calls at a strike that is at or above the price I paid for the shares. Since this is a trading strategy, I am not interested in buying on margin and keeping SPDR Trust (SPY) in this portfolio.

My take will be to sell covered calls on the assigned shares at or slightly above the price I paid for them. If I got assigned at $150/share, I would either sell a covered call expiring in 4 – 6 weeks with a strike 150 or strike 151. My goal is to dispose of the shares as soon as possible, because I am paying a margin interest on them. The goal is to not sell shares at a loss. If I were unfortunate enough to sell SPY at 150, and the price fell too much under that price, I would probably extend the maturity by a few more weeks.

The worst risk I can think of with this strategy however is if my portfolio decreased by 75%, and my options get assigned at a price that is substantially higher than current prices. If that $60,000 drops to $15,000 and I have to spend an additional $15,000 to purchase stock worth $3,750 I might be close to getting a margin call. The goal of investing is to minimize losses to principal that would result in a wipe-out of investor assets. I believe that by only allocating 25% of assets to this options strategy, I would have an adequate margin of safety that could provide some protection to principal. In addition, by using options that expire within a month or so, the risk of steep adverse declines are minimized. Stocks do fluctuate, but the likelihood of a 75% decline in one month is remote.

At the end of the day, this strategy would likely generate approximately $100 - $150/month in additional income for a portfolio valued at $60,000, if a conservative 25% allocation to the strategy is used. While this is a small stream of income, over time it can turn into a small fortune by the mere power of compounding. If you set aside $100/month and earn 7.50% annual total returns, you will have $17,793 in ten years.

Full Disclosure: Long MCD, Short SPY June 148 Puts

Relevant Articles:

The pros and cons of selling covered calls on dividend paying stocks
Covered Calls for additional income
An alternative strategy to covered calls
Build your own Berkshire with dividend paying stocks
Stress Testing Your Dividend Portfolio

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