Tuesday, September 9, 2014

Selling Puts: Pros and Cons for Dividend Investors

Last week, I sold some puts on British Petroleum (BP), right after the judgment that opened the door for a potential $18 more billion in liabilities stemming from that Gulf of Mexico oil spill from 2010. The stock price sold off sharply on those news, and I decided that this was an opportunity to add to my existing position. Since I am low on investable funds, I decided to sell some puts on British Petroleum. I posted this over the internet, and had a reader ask me exactly what that means. As a result of this question, I am going to try and respond to this request.

A put is an options contract, that allows the options buyer to sell a number of shares at a given price at a given date in the future. The number of shares per each options contract is 100. People buy put options in order to protect themselves from a decline in prices, and thus they want to limit their losses. Those who purchase put options are therefore either hedging their exposure, or outright trying to place a bet that prices are going to decrease. For the right to sell a number of shares at a given price into the future, the options buyer pays the options seller a premium. This is essentially the cost of the bet behind the option. The premium is essentially the price that the put options buyer pays to the put options seller.

The put options seller receives the premium, and has a few potential outcomes for him. In my case, I sold a put option on BP at a strike of $44, which expires in April 2015. I received an options premium of about $2.25/option. This means that the options buyer ( the person I sold the option to) paid $225 for the right, but not the obligation, to sell me 100 shares of British Petroleum at $44/share in April 2015.

I essentially have two potential outcomes from this transaction:

The first outcome is that shares of British Petroleum sell for more than $44/share by the time the options I sold expire in April 2015. As a result, those options contracts expire worthless, and I end up with the $225 in premium in my account. The downside in this outcome is that I missed out on all potential gains above $44/share, if the put is never exercised.

The second outcome is that shares of British Petroleum sell for less than $44/share by the time the options expire in April 2015. As a result, I would have to purchase 100 shares of BP for every options contract I sold to the buyer of the put option. If shares of British Petroleum sell for $40/share in April 2015, I would knowingly buy shares at around $4 lower than then present prices. All is not bad however since I received $2.25 per each share, which essentially lowers the cost to about $41.75/share. In addition, buying at $41.75 sure beats buying at $44 or $45/share outright. The share was selling around $45 immediately after the unfavorable court ruling.

In both first and second outcomes, I am not eligible to receive any dividends on British Petroleum, since the buyer of the put option holds those shares in their own brokerage account. If exercised under the second scenario, I would own some shares in the British oil giant, and receive those fat dividends ( assuming they are not cut or suspended). Astute readers can see that as long as the stock price is flat or up, I get to keep the premium. If the stock price is down, I get to buy shares in a company I am interested in, but at a lower price. It is a win-win for me, that slightly tilts the odds of success in my favor.

However, I used the premiums from the puts I sold to purchase shares in British Petroleum. This means that for every put contract I sold, I was able to buy 5 shares in British Petroleum. I will be earning a nice dividend check on those shares for years to come, since I rarely sell those companies that at least maintain their dividend payment. If shares sell for more than $44 in April 2015, I will have essentially earned 5 shares for every options contract I sold on BP. The nice part is that I would have earned those shares only because I have good credit with my brokerage. Even if I have to buy BP at $44, my entry price would be much better compared to buying the stock outright today. Hence, I view selling puts on stocks I want to buy either way as a type of “heads I am better off than before, tails I am even as before” strategy.

Here comes the danger in selling puts however – the possibility for wipeout risk due to overleveraging. Let’s assume that my portfolio was valued at $10,000, and I sold a put on BP with a strike of $44. If the value of BP stock decreased by 50% in April 2015, and I needed $4,400 to buy BP stock, while the value of my overall portfolio dropped by 50% through April 2015, I would be almost wiped out (assuming other shares in my portfolio also decrease by 50%). This is why it is important to be very careful when playing with leverage, which is akin to playing with fire.

I only sell puts sporadically, and only do it on companies I would like to buy outright, but whose prices are little too rich for my taste today. In addition, I make sure that the potential outlay if all puts are exercised does not exceed 25% of the account value on the stock account through which I do that options trading. Long-time readers also know that I have more than one stock brokerage account, which further reduces wipeout risk.

Full Disclosure: Long BP and short BP puts

Relevant Articles:

My mini-Berkshire strategy for selling insurance through puts and calls
The pros and cons of selling covered calls on dividend paying stocks
An alternative strategy to covered calls
Dividend Paying Companies I recently added to my income portfolio
Check the Complete Article Archive

25 comments:

  1. I use puts to purchase shares consistently and I wanted to add my 0.02 cents (100 shares per contract = 2 cents...)

    US put options can be exercised even before the expiration, especially if they are "deep in the money".
    This usually happens if the stock dropped a lot and nobody else wants to buy this put from the person that bought it from you.

    We should also keep in mind that nothing stops us from "buying back" the puts we just sold if we think the share is going to drop too much.

    Lets compare the scenario where the shares dropped by 50% between buying the stocks and selling a put.

    Buying stocks:
    If you bought 100 shares at $44 and you sell the stock after it dropped to $22 than you lost $2,200 (44*100-22*100).

    If you Sold a put for $225 and the stock fell to $22 than you can probably buy the put back for ~$2200 (the passage of time between the time you sold it and the time you purchased it back reduced the cost of the put - this is called "time decay" and calculated using the Greek letter "Theta").
    In this scenario you got $225 from the sell of the put and paid $2200 to purchase it back so you lost only $1975.

    When selling a put you are in a better position than the person who purchased the stock even when the worst scenario happened!

    There are only 2 real down sides for selling puts:
    1. Most people don't understand how much they are risking.
    As long as you know that your real risk is the price of the stock (multiplied by the contract size = 100) and you make sure you can cover it than you are OK.
    2. If the stock decides to sky-rocket to the moon than you are left on earth choking on the smoke everybody else left you with...

    As long as the stock behave normally or even if it drops like a rock than the person that sold the put will be in a better position than the person who purchased the shares.

    I've yet to encounter any situation where a person that sold a put was in a worst situation than a person who purchased the shares at the put strike price (with the exception of a sky-rocket stocks mentioned above).

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    1. Look up "then" vs "than". Hard to read.

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  2. Another comment I have on this subject is picking the expiration when you sell a put.
    Personally I prefer to sell puts for between 30 and 60 days.
    The 4-6 weeks period is called the "sweet spot" for "Theta decay".

    In human being language this means that I'm getting payed more money PER DAY than selling an option due to expire in 3 months or in less than 1 month.
    Take a look at this chart of "Theta decay":
    http://www.tradingonlinemarkets.com/Articles/Options/time_decay_option_chart.gif

    Notice how it starts to go down faster when you hit the "57 days to expiration"?
    The reason you won't have much benefit from theta in the last 30 days is because most strikes will either be worthless out of the money or very expensive in the money strikes.
    Either is not good for a Dividend Growth investors like us.



    What I like the most is selling those put options where they expire at least 2 weeks before any scheduled dividend or earning report.

    When you sell puts with this in mind you usually get ~1%-1.5% return in the 2 months period without even buying the stock yet.


    Allow me to demonstrate with a real life case-study from my own trading log (read: an excel sheet where I keep track on all my trades):
    On July 17th I made a decision to purchased DE (you all familiar with it, DGI already posted an analysis about it in the past).
    DE was traded for $89 at the time.

    Instead of purchasing the stock I sold August 15th 2014 put with a strike price of $87.5 and received $126 as premium.
    $126 premium on 100 shares that cost $89 each amounts to 1.416% return in less than 30 days.

    On August 13th I saw the stock price standing at 86.5 and decided to "roll" my put to September 19th 2014.

    I bought back the original put I sold for $161 and received $250 for the put I purchased.
    In total I received $250+$126=$376 and payed $161 which amounts to $215 profit.

    Considering the original cost of the stock at the time I wanted to purchase it this amounts to 2.416% return in 2 months and I still don't owe the stock!

    On August 25th I saw the stock price drops further to $84.96 and figured there is a good chance it'll get even lower by the expiration so I decided to replace my $87.5 strike put with a $85 strike put of the same expiration (which happens to be before the next ExDividend date).

    I bought back the September 19th 2014 $87.5 put for $294 and sold the September 19th 2014 $85 put for $127.

    What did I get from all of this you may ask?
    Well, this is the current situation:

    I received $126+$250+$127=$503 and payed $160+$294=$454
    In total I pocketed "only" $49 for 2 months of NOT BUYING THE STOCK! (0.5% return for 2 months without buying the stock, this is better than the dividend payment!)

    If the stock will trade for less than $85 on September 19th 2014 than I'll purchase 100 shares for $85 with an effective cost of $85-$0.49=$84.51 per share (after deducting the profits from the put sales).
    In the alternative of just purchasing the shares from the get go I would've payed $89 per share for 100 shares instead!

    If DE will trade for more than $85 per share on September 19th 2014 than I won't be purchasing the shares but I'll still keep the 0.5% return I got from selling the puts instead of getting the dividends of $0.6 per share.
    In the alternative of just purchasing the shares from the get go I would've payed $89 per share for 100 shares with effective cost of $89-$0.6=$88.4 when deducting the dividend for September!

    PS
    I ignored commissions in the numbers above because they depend on your broker and your commission plan.
    After commissions, my profit from all those puts is $41.32 and not $49.

    I hope this helps someone understand the huge benefit selling puts can have on a long term DG portfolio.

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  3. Also, I am not sure the wipeout risk really exists for you because you would never purchase more puts than you would like to actually purchase in shares. Since BP wouldn't be 50% of your portfolio, the losses you could take here would be much smaller.

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    1. Well, I mentioned wipeout risk because it is important to be careful about leverage in general. It is very easy to go out and possibly sell options that could trigger an unfavorable event in an unfavorable environment. It is something to consider, and I might not have explained it well with the numbers I presented. As usual, it is better to be safe than sorry ;-)

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  4. I've been looking at options as a way to get more money through dividend stocks that I already own. Do you have any suggestions on books/articles I can read to understand options better?

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    1. You might find the articles linked on this article helpful. Other than that I don't know about a book, but if you start your search using google, you can find something I am sure.

      I would not sell covered calls on stocks I own, since I am giving up upside for a few bucks. But others are willing to do it.

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    2. George Acs' book: Options to Profit and his website are good places to start. Also, Fidelity website has a good section on learning options.

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    3. There are a lot of articles in the web and videos on YouTube explaining how to do something called "Covered Call" strategy.
      In a nutshell this strategy means you are agreeing to sell your shares for a specific price even if the stock price goes to the moon.

      As a DG investor (I want to say DGI but I guess it's reserved for DGI in this site...) your plan is to never sell shares, especially when they go to the moon.

      Those who advocate for selling covered calls states that you are already making profit when you sell a call with a strike price higher than the stock price so you both get to keep the premium and the price appreciation between the original stock price and the call strike price.

      In practicality the call option prices are much lower in comparison to the put options (due to volatility, I can explain this in more details if needed) which makes selling covered calls bring in very low reward for the risk of giving up a winning stock we don't really want to sell.

      The covered call strategy is great for people that doesn't want to keep a stock forever, they pick a price where they'll be comfortable selling the stock and then sell a covered call on that strike until it works itself out.

      There is another risk which most trader ignore when selling call options - early exercise a few days before the Ex-Dividend date.

      What this means is that if the call option you sold is close enough to expiration or deep in the money where most of the value is "intrinsic value" (value derived from the stock price as opposed to time and volatility) than the call buyer will earn more money by exercising the call resulting in him getting the shares AND THE DIVIDEND.

      In this scenario (which is more likely than most lead you to believe) the call seller ends up loosing both the share he didn't really wanted to sell and not getting the dividend he wanted to get.

      In general my experience thought me that covered call strategy has more downsides than upsides for a DG investor like the DGI followers.

      The best way to use options in our case is to sell cash-secured puts in order to purchase the shares.

      As both DGI explained in the article and I explained in an earlier comment selling cash-covered put will give you instant profit from the premium which is more often than not a lot higher than the dividend as well as higher chance to get the stock for a discount just after a dividend (due to the fact that the stock price falls just after the dividend) those reducing the cost basis of the stock.

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  5. Could you explain your rationale for selling puts that expire in April 2015 (seven months away) as opposed to selling puts with a shorter time frame. Seems like the time risk is too great. Also, why did you sell the $44 strike rather than a lower strike? Once again, the risk seems too great. Are you trying to get into the stock at a lower price or are you just trying to make additional money selling puts? Thanks for your respons.
    Dennis McCain

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    1. Hi Dennis,

      As I explained what I am trying to do in the article above, "I only sell puts sporadically, and only do it on companies I would like to buy outright".

      I generally try to match up future liabilities with future potential cash inflows/deposits. I don't have $44/share for BP right now, but I will in April 2015. I also try to earn 5% - 10% on put options sold. Otherwise, it is not worth to sell a put every 2 months.

      I am not sure what you mean that the risk is great. What exactly do you mean? After reading the article above, how did you reach this conclusion?

      In general, options are not something that beginning investors should dabble in. I am not a beginning investor, hence I do it.

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    2. What he means is that a lot can happen in 6 months.

      A company can cut dividends in 2 months and you will still have the obligation to buy it even though it won't fit your entry criteria anymore.

      These scenarios are unlikely but not impossible.

      It's true that you can always buy back the put you sold and eliminate your obligation but you are still missing on the time-decay.

      Options between 6 months and 2 months lose very small amount of premium to time decay.

      If you compare it to options which expire in the next 60 days there is a considerable difference.

      It's true that we should keep an eye out for commissions which can turn the tide around and make short-term options not worth it but in general I always try to sell puts for at most 2 months in advance (as I explained and demonstrated in an earlier comment).

      So the question that is still left open by Dennis McCain (which I'm also interested in hearing the answer to) is:

      Is there any reason beside available capital which made you decide to sell a put that expires 6 months away instead of selling a put that expires 2 months away and repeating the process 3 times (assuming the stock still fits your entry criteria when each put expires worthless)?

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    3. But I answered the question already. Just read the article, read my responses and piece it together.

      There is no incremental risk in selling a put versus buying the stock outright, assuming you wanted to buy the stock in the first place. You should not look at things in isolation. But every investment carries a risk of losing all of your money. This can never be eliminated.

      As a dividend investor, my goal is to hold a stock for 30 years. If you are afraid of the next 2 - 7 months, you should not be in stocks at all. You need to tuck those money away in a certificate of deposit.

      Not a recommendation to buy or sell.

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    4. You did bring a point on the 2 month though...

      I guess to add to it, if you want to get in at $44 at BP, selling a 6- 7 month put sounds like having a better chance of getting at $44. If you sold a put every 2 months for 6 - 7 months, there is a chance that you will be exercised right away in 2 months and therefore have an effectively higher cost. If you are not exercised, you can sell another in 2 months but then you never know if the 44 put will be worth anything if say the price goes to $50. I am talking about the puts in the second and third 2-month window. When you shorten your time horizont, you are essentially playing with stock price fluctuations. When a small investor plays for stock price fluctuations, they have the odds against them.

      So you are introducing an extra level of uncertainty that you will get into the best price, but you might earn more in premiums. It is a tradeoff. Another thing to consider is the hassle factor and commissions as well as taxes. Per my understanding, if my options were to expire in April 2015, the income is taxable in 2015. If I sold a 2 month option that expires worthless I get to have taxable income this year. And since they increase the dollars to hit a bracket every year, it might make sense from a tax standpoint to go in the next year.

      And January 2015 is out of the question - I already have several puts potentially expiring.. Although it looks the odds are 50/50

      Actually, I like selling longer dated puts. This is because a business usually gets more valuable in the future, which per my understanding options formulas do not take into account. Too bad unfortunately that we don't have puts out through say 2018 - 2019. The longest I see is Jan 2016 for most companies and Dec 2016 for SPY.

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  6. DGI,
    I have never really used options, and your explanation was pretty good. I find myself looking at the equation a little differently, however. If you bought 100 shares of BP at today's closing price of $45.15, you would receive $117 in dividends before April (Dec and March pay-outs), making your cost effectively $43.98 (45.15 - 1.17) per share at that time. That's only a couple dollars more, but no risk of missing out if BP stock gains in the next few months (the ruling could easily be overturned, for example). If options work for you, then you should stick with them. I guess I'm just more of a bird in the hand kind of investor.
    Thanks for the lesson,
    KeithX

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    1. Hi Keith,

      If the option is exercised by April 2015, the effective cost is 44 - 2.25 = 41.75/share. This is better than buying today, and having the dividend reduce your cost. Also I do not have the $4400 behind each options contract today sitting in cash. I will have that amount in April 2015.

      If BP goes to $50, I will have missed out on the gain, since I would have only earned $2.25. If BP goes to $30, my loss would be less than buying outright.
      Of course, a temporary fluctuation in quotations is not a loss, unless you panic and sell. The loss is permanent if you sell, but if you think that BP will weather this storm, it might make sense to hold. I don't like the fact that BP is made into a scapegoat. Of course I might be biased, since I have a position in the company. I am wondering whether they couldn't move the place for the case to a more business friendly state than LA. I am not a business law expert, so it is possible that I am talking out of my hat on that one.

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  7. This comment has been removed by the author.

    ReplyDelete
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    1. Hi Suzanne,

      Start with google. Search for the company's name. Go to the company's website and read the annual report.

      Or you can go to sec.gov, and find the latest 10-k there.

      This is where your research should start for any stock you are researching.

      Best Regards,

      DGI

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    2. This comment has been removed by the author.

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    3. On the msn money website you can find almost anything you want to know about the stock. I did not know this. Shows you how much I know about computers.Suzanne

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  8. I just closed the BP puts at a small profit. Not interested in the company at the time.

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  9. Interesting article and comments on how to use options as dividend investor.

    There are some interesting thoughts that popped up.

    My current approach is to use puts to get a better return on my money than via my savings account. I will write a put on a company that I don't mind owning in my future dividend portfolio. At the basis, I am an index investor, but DG will be my alternative portfolio.

    I also appreciated the comments on covered calls. It is true that the risk is to loose the stock and that the premiums are quite low. Yet, I do this anyway, as DGI is not yet part of my investment goal.

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  10. I'm a bit confused about the responsibility of the option put seller - is he liable to pay the dividends? I get conflicting answers when I google. And on my trading platform, it says cost of options $xxx, not including dividend risk.
    Really hope you could help me understand this.

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    1. When you sell puts, you receive no dividends. The owner of the stock receives the dividends

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