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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

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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
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