Tuesday, June 5, 2018

Making money by selling put options

In the last post we discussed that reducing management fees is an important way to improve portfolio performance but that optimizing your return on cash holdings, even at minimal interest rates can improve your overall performance from a fictional return of 5.6 to 6.0%. That is a nearly 10% performance improvement. We also showed how to use the cash in your portfolio to protect a naked put sale. We showed a fictional example returned in the best-case scenario 10% over a 2 month period or 60% per year on the dedicated cash. Sale of puts also reduced your down side compared to purchasing stock outright.

In this post we sell ‘naked’ (not covered by my stock holdings) puts in real life. My discount brokerage account has over U.S. $10,000 in cash. We like Walt Disney stock which is trading near the bottom of a trading range between $97 and $105 per share. Over the long term, I think Walt Disney is a core holding representing a rock-solid company. I don’t mind buying more shares around $97.50. But, I would love to buy even cheaper.  Right now, it is trading around $100 per share.  Thus, I could put in an offer to buy 100 shares at $97.50 and wait.  Or… I can write a PUT option which obliges me to buy Walt Disney for $97.50 (strike price). And I am willing to do so over the next two months (term of the option). The market has been a bit volatile for Disney, so has the stock market in general. The buyer of my put would be afraid of losing money on Disney if his/her shares falls further.  If Disney would fall below $97.50 he wants to sell it guaranteed rather than crashing through that price level to an even lower price. For him, it is basically a forced sale at a certain price equivalent or a stop-loss sale. I would be the counter party promising him to buy the shares at that price… but NOT for free. The buyer of my put must pay a premium for that protection, I am in fact a mini-insurance company.
From my side, I think buying Disney at $97.50 as a long-term holding is a good deal. So, why not sell a put and collect a premium that is a bit higher than last year because of recent market volatility. Increased volatility has pushed up option premiums and writing puts may be worth my while. I don’t know who my buyer is; just like I don’t know who buys or sells shares. But there is likely a buyer for my puts out there (supply -me and demand – he or she).
This is a naked put option. Meaning, I better protect myself and have the money if the put option gets exercised. As said I have the cash in my account and commit to hold that over the term of the option (approx. 2 months). An option contract is a bundle of options. One option per share. The option contract is always for a lot or 100 shares. If the option trades at a premium price of $1 per option, then the price of the contract is $100.
My commitment for 1 contract is to buy 100 shares of Walt Disney for $97.50 per share or $9750. That is how much cash I should conservatively hold in my account for the term of the option (i.e. the next two months in our example).  The option premium for the put option is posted at the discount broker screen (see below) on the right side as ‘Bid’ (highest price offered by a buyer in the market) versus an ‘ask’ (lowest price at which the counter party is willing to sell).  Just like when you bargain when buying a car or something on KiJiJi, you bargain here. I am willing to sell a bid cheaper than the ask. In this case, I am willing to sell my option in between the bid and ask, say for $1.66 per option.  In this case, I did not get a sale and the market ‘moved on me’. I changed my bid to $1.62 and sold. For now, let’s fill out the brokerage screen shown below covering.
I start by entering the ‘Walt Disney’ or if I know its Symbol by heart, I enter DIS. A list of potential targets shows below the field and I selected DIS US.
Then I have to specify the option(s) I want to sell. From a list of expiry dates, I select something approximately 2 months out. July 20, 2018 is an available expiry date. Next, I select the strike price and finally the option type: in our case Put. The pricing detail shows up on the window’s right. It shows there is a potential trade volume of 9,010 contracts and the investors closest in price currently ask (for sellers) $1.67 and the highest bid is $1.64.  Now these numbers continuously change. For example, if my ‘ask’ is $1.65 then, when I enter the trade it will become the new ask. Twenty contracts are offered at bid price are available for purchase and there are 7 contracts (options for 700 shares) available at the ask price .
When I enter on my side of the screen the purchase price, I can do so using several ways. I can set the price at ‘market’ and I will purchase at the price that the market offers right and then. Some market players can manipulate the market price in a matter of milliseconds (e.g. high frequency traders). So, the market price may jump from what you see as ask on the screen. I you would be obliged to pay the ‘market price’ regardless of what the screen shows. It is better to set the price (limit) and maybe miss out. Like I did at $1.66. You now have the choice to walk away or change your bid. I always, ALWAYS use ‘Limit’ and then set my price ($1.66 on the screen).  That means I sell 1 contract (Quantity 1) for 100x $1.66 minus commission (varies based on the number of contacts; typically: $9.99 for the first plus $1.25 for each additional contract).  In case of sale, the proceeds would be $156.00.  If you do this stuff at a full-service broker they can easily charge $100 in commissions and then your part of the sell is a take home of $166 minus $100 or $66. Considering the risk, that is not worth it and thus I always trade options via a discount brokerage.
Action selects whether I want to buy or sell the option; whether I sell naked or cover (i.e. I already own the underlying stock – applicable when selling covered calls). We select to open a new position by selling a put of stock we don’t own (uncovered or naked).

I check the input details and usually I make the offer to sell the naked puts for just the day. That means if nobody buys my put within the same business day then the deal is cancelled (historical). Usually, I sell or buy options in a matter of minutes. If I don’t sell after a minute or five, I tend to change the premium price or let the deal expire at the end of the day.  I check the details and make sure everything is posted correct. Then I enter my trading password and push execute (submit)_. The brokerage gives me one more chance to confirm the details of the deal and when I confirm it goes to market. I can track the trade on-line on a trade status screen. Thus, I know whether the deal is still on or whether it is done. There is also the opportunity to cancel (only when the transaction hasn’t gone through yet) or to edit the terms of my offer (only when it hasn’t gone trough yet).  Make sure you fill everything out correctly!  This is not a kiddie game.

Let’s see what possible outcomes this trade may have (below the screenshot). 
Click to magnify

We sold our put for $1.62 and collected $152 or so. The $152 proceeds goes into our cash and the option contract shows up on our holdings screen in a matter of seconds. We are now the ‘counter party’ of a put option.
There are three (five) possible outcomes.

1.       Disney trades after 2 months at or above the strike price. You don’t have to buy the shares at $97.50. The option expired worthless and you are the proud owner of $152.

Suppose you did the same trade every 2 months during the year or 6 times. Then you collected 6 x $152 or $957. For that you held $10,000 cash to cover an eventual purchase. You made a return of nearly 10% on your cash – better than any one- or even five-year GIC that I know of. And… you could have collected another percent or so as interest on the cash balance in the brokerage account (If they pay interest).

2.       Disney fell to $97.50 and you purchased the 100 shares for $9750. BUT you also received $152 option premium. So, your acquisition costs are not $97.50 per share which you were happy to pay. Rather you bought for $97.50 - $152/100 = $95.98 per share.  Even better!

3.       Disney fell below $97.50 to $95.00 or whatever lower price.  You bought for $97.50.  If you bought those shares for that price without selling the put options, you would have lost $97.50 minus $95.00 or $2.50 per share or $250 (if you sold). With the sale of the put option you lost not $250 but rather $250 minus $152 (the option premium). You lost LESS.
So whichever way you turn it. The sale of the put option made you always better off than if you hadn’t.  That is a no-lose game. It is in fact a very conservative way of buying your shares for less than anyone else. There are some hooks here. If you let an option expire and it gets exercised by the discount-broker; you typically pay a heavy commission: $42 or so. It is better to sell the option for a loss just before the expiry date and buy the shares when they trade at $97.50 or a lower price. That way your commissions would be around $18, and you have the same (or better results – especially if the price fell even further) as if you’d bought the shares at $97.50. Avoid the costs of having the broker exercise your obligations (except when the options expired worthless and nobody has a reason to exercise them – case 1).

It is possible that the price of the shares that underly your put option shoots up in price like a rocket far before expiry. Say, you cashed your $152 and a week or two later the options trade at around zero. Buy them back immediately and now you made your 10% or so return in 2 weeks time. If you could pull off such a deal every 2weeks you’d make 26x10% or 260% per annum (not likely). But it allows you to sell more options and make more profit using to underlying $10,000 cash to cover another new trade.

Some people are so good at trading options they don’t want to own any stocks if they can avoid it. This is rare though!  For us selling put options is a way to increase our cashflow in a conservative fashion. You cannot only make an extra buck by selling put options but also can sell call options. Whatever you do though, make sure you can fulfill the obligations that you took on by selling those options. The above was a real example. I hold 1 contract for Disney and I may follow up on this blog with the final results.  He, you might say that I do make money from this blog after all! 😊

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