September 5th, 2008Selling Puts For Income, Or As a Cheaper Investment
It was a pretty brutal week in the markets this week, especially for the long investors. The Dow Jones lost 2.8% for the week. The S&P 500 lost 3.2% and the Nasdaq was off even more at 4.7%. In markets like this, hedging the downside is crucial, as is maintaining cash reserves. The cash reserves can be used for modest returns (2-4% in treasuries or CD’s) and is also very handy to buy deeply discounted stocks after a vicious week like the one that just ended.
The volatility index (^VIX) closed up over 12% for the week. It topped out at 24.67 and now sits at 23.06, a healthy and potentially profitable level for outsized returns by SELLING options. Covered calls are one way to play the increased volatility. But selling puts can be just as effective. There are two methods of selling puts - naked and covered.
Recall that the buyer of a put has the right to SELL shares of the underlying at a predetermined price, for a predetermined duration. That means that the seller of a put may be forced into buying the shares that the put buyer is PUTTING to us. The best time to sell puts is when volatility is high (as the shares go down, volatility generally increases), and when you are willing and able to purchase the shares at a later date, and for a lower price, if they are put to you. Let’s explore the idea, using some of the Dow Jones components as examples.
Exxon Mobile (XOM) closed the day at 75.62. The September 75 puts traded last at 1.36. If you sell to open (1) contract of the XOM September 75 put, you will bring in a credit of $136. By selling the put, you are granting the buyer the right to force you to buy 100 shares of XOM for $75 per share, or $7,500. For this reason, most brokers will require you to maintain $7,500 of cash or margin in your account to cover the potential purchase for as long as the put contract is open. As long as XOM remains above $75 through September expiration, then you will not be forced to buy it for $75, and that initial credit of $136 is yours to keep. If XOM goes below $75 prior to September expiration, then you may be forced to buy 100 shares for $7,500. However, in this case, when factored with the initial credit of $136, your effective purchase price is only $7364 (7500-136 initial credit). If you liked XOM enough to buy it at $75.62, then in many cases it makes sense to sell a put in lieu of buying the shares outright. The risk of selling the PUT when compared to buying the shares, is that any significant rally in XOM shares goes on without you. Your maximum credit by selling the put is only $136 in this case, regardless of how high XOM goes.
As another example, consider Boeing (BA). It closed today’s session at 62.89. The September 60 put last traded for .90 ($90 credit per contract). The October 60 put last traded for 2.00 ($200 credit), and the October 55 put last traded for .80 ($80 per contract). If you are willing to own 100 shares of Boeing for $55 or $60 per share anyway, then selling one of the September put contracts in lieu of buying the shares may work in your favor. By selling the puts, you may be forced to buy the shares at the agreed upon price (strike price), but if not, the initial credit is still yours to keep anyway.
Put Options : How to Use This Powerful Financial Tool for Profit & Protection by Jeffrey M. Cohen
Note and Disclaimer: examples used are arbitrary and not recommendations.