Using Options to back into a position

[bcvaluation]

Does anyone have any experience with or comments about selling puts (about 6 months out) on a stock that you find to be a good value investment selection but is currently trading a little bit above your desired purchase price?

 

If the stock moves up or stays were it is, then you bank the credit you received for selling the puts.  If the stock moves down, you get the stock put to you at a price that you find to be agreeable with your evaluation of the companies intrinsic value.

 

I'm wondering if folks have done this and found that they regretted not just buying the stock outright (maybe they missed some good upside movement).

[Guest Grey512]

I've done this. In 'expensive' markets, I found even the sheer knowledge that I could do this a great disciplining mental device to prevent myself from engaging in more buying activity than I perhaps would have otherwise. I did not do this too much but I guess one issue with the approach if you overdo it is that you may end up nearing your margin requirements. In a market crash (even as modest as one we had in August), you might have to deposit more equity into the account. Volatility can spike in weird ways, so selling volatility is generally considered risky for that reason. But shorting puts on great businesses is the least bad vol-selling idea out there I guess.

[TwoCitiesCapital]

Does anyone have any experience with or comments about selling puts (about 6 months out) on a stock that you find to be a good value investment selection but is currently trading a little bit above your desired purchase price?

 

If the stock moves up or stays were it is, then you bank the credit you received for selling the puts.  If the stock moves down, you get the stock put to you at a price that you find to be agreeable with your evaluation of the companies intrinsic value.

 

I'm wondering if folks have done this and found that they regretted not just buying the stock outright (maybe they missed some good upside movement).

 

I regularly do this when looking to increase positions. I tend to be a little early when I start purchasing so this helps slow me down and prevents premature accumulation. I typically sell 1 to 2 month options 10-15% below the current strike price if I can get a premium that pays me ~2% per month. This generally means waiting for a volatile decline (like an earnings miss) or something, selling the options, and then continuing to roll that exposure for as long as the premiums stay high. There are a few end scenarios:

 

1) Stock price declines, but not quickly enough to hit your strike price - pocket your 2% and determine if you want to buy the stock now or rinse/repeat with options.

2) Stock price declines and hits your strike - you enter the stock more cheaply than you would have originally

3) Stock price skyrockets and you keep your 2%

 

My ideal situation would be a 1) for a few months as the price drifts lower and I keep collecting premiums until I have made 4-5% on the cash and can get the stock 10-15% cheaper. Of course, it doesn't always work out that well and you will miss some opportunities doing this.

[scorpioncapital]

Why bother with 6 months out? You can do 'impatience arbitrage' by selling a weekly put for 5 to 10 cents 2-3 days before expiry from those who just can't wait to close out instead of let it expire. If the strike is far out relative to market price then one has to ask how desirable the stock is at current prices OR how wrong one is on the valuation :) If one is wrong on the valuation, the put will yield a little profit but give up much more long term. If one is right, then not much is lost but then you still have to buy the stock if it gets close to the strike area so you'll be in monitoring mode.

 

 

[rpadebet]

I currently do this and I think of this as selling insurance..

 

I try to sell insurance on:

1) The most insurable assets (names you would like to own if the price was right)

2) Diversify you exposure across multiple assets (because even the best quality ones can sometimes get into trouble)

3) Sell when insurance is in demand (vol high, typically after a correction like we had this year)

4) Size positions such that you are able to "make good" on the insurance (manage the margin call scenario)

5) Size deductibles appropriately (choosing appropriate strike depending on the name)

 

I do this for 6month to 1 year term. I want to own the assets I am selling insurance on (hopefully not all of them together!). If I get put on 20-30% of the names, then my cost basis is net of the strike paid on the names put and the insurance premiums received on all the names. If I don't get put anything, the income doesn't hurt and is a form of synthetic dividend on my core portfolio.

 

Anyone see any major blind spots with this?

 

 

[BTShine]

It's a solid plan as long as there's enough cash to make good on your commitments.  There's always the chance of a crash or big drop in prices, therefore triggering these puts.

[Pelagic]

I've done it with mixed results, always with cash secured puts no margin. The weeklies or close month are the way to go IMO and just think of it like having a buy order at the strike. It's a decent way to reduce basis when you're buying but I think you miss out occasionally on the very volatile days where a better price might be offered. For a portion of your desired allocation though I think it makes sense.

[kiwing100]

It's a solid plan as long as there's enough cash to make good on your commitments.  There's always the chance of a crash or big drop in prices, therefore triggering these puts.

 

Potentially very dangerous to your financial well being.  Take a look at Pershing Square Capital management's experience with VRX ... big margin call when the stock price fell 50% in one day.

[TwoCitiesCapital]

It's a solid plan as long as there's enough cash to make good on your commitments.  There's always the chance of a crash or big drop in prices, therefore triggering these puts.

 

Potentially very dangerous to your financial well being.  Take a look at Pershing Square Capital management's experience with VRX ... big margin call when the stock price fell 50% in one day.

 

Retail investors wouldn't get margin calls for cash covered puts.

[bcvaluation]

Thank you all for the insightful input.  I was planning on doing this with enough cash/margin clearance to buy if the stock price drops below my strike.  The reason I was choosing 6 months out was to collect enough premium to make it worth while (a synthetic dividend with a decent yield). 

Although, I see the temptation to sell more puts than I can really make good on if I have to buy, playing the odds that it most likely won't be the case that everything will drop below my strikes.  But that is a bit more risky. IMO

 

[bcvaluation]

What does happen to retail investors then?

[bcvaluation]

It's a solid plan as long as there's enough cash to make good on your commitments.  There's always the chance of a crash or big drop in prices, therefore triggering these puts.

 

Potentially very dangerous to your financial well being.  Take a look at Pershing Square Capital management's experience with VRX ... big margin call when the stock price fell 50% in one day.

 

Retail investors wouldn't get margin calls for cash covered puts.

 

What doe happen then?

[LC]

It's a solid plan as long as there's enough cash to make good on your commitments.  There's always the chance of a crash or big drop in prices, therefore triggering these puts.

 

Potentially very dangerous to your financial well being.  Take a look at Pershing Square Capital management's experience with VRX ... big margin call when the stock price fell 50% in one day.

 

Retail investors wouldn't get margin calls for cash covered puts.

 

What doe happen then?

 

when you sell puts you assume the obligation to buy the stock at a certain price. your liability is limited to the strike price. if you are cash covered, you have the funds available to purchase the stock at that price. so your broker just executes that transaction.

[Graham Osborn]

The strategy makes sense if you are a cold-blooded value investor, meaning you will be willing to buy into a death slide even thought the trajectory suggests another 20-50% fall as may happen in a fast moving bear market.  Investors have a funny way of seeing "value" differently under those conditions.  So you just have to realize you are handcuffing yourself to a course of action that future events/ information may render less desirable.  Of course, if you discover the fundamental/ macro problem yourself before the crowd you could still rescue the position.

 

For myself, I don't buy into death slides, so this type of trade would restrict my ability to listen to what the ticker is telling me.

[TwoCitiesCapital]

The strategy makes sense if you are a cold-blooded value investor, meaning you will be willing to buy into a death slide even thought the trajectory suggests another 20-50% fall as may happen in a fast moving bear market.  Investors have a funny way of seeing "value" differently under those conditions.  So you just have to realize you are handcuffing yourself to a course of action that future events/ information may render less desirable.  Of course, if you discover the fundamental/ macro problem yourself before the crowd you could still rescue the position.

 

For myself, I don't buy into death slides, so this type of trade would restrict my ability to listen to what the ticker is telling me.

 

You're not handcuffing yourself any more than you would be by owning the shares outright. You can always buy the options back...

 

If you're selling the options OTM and collecting a reasonable premium, it's actually quite likely you come out ahead buying into a stock in a "death slide" using puts than you would by buying the stock outright. Especially if the "death slide" was already in the midst of occurring and the put premiums were high.

[scorpioncapital]

Strangely enough, I see the selling of put options to potentially establish a position as being the very opposite of the word 'option'. You lose all the optionality of buying at a lower price or maybe not buying at all if the strike price is not reached. All in all, I prefer the option to buy at whatever price seems best whenever the time is right. If I was just wanting an income stream I'd take very deep out of the money puts and assume it's purely an income operation with no desire to own the company at all.

[wachtwoord]

Of course it's the inverse of an option. You are selling the option to do something to someone else (reducing your own options).

[philippoc93]

This might be a silly question and comes from someone with no experience of options - just starting to learn  :).

 

What I haven't been able to visualise in my head as of yet is; why would someone leave that cash pile just sitting there doing nothing? Yes, you earn the premium and can roll the options from period to period as an income stream, but there there must be surely a better way to get the most of your money? Is the premium really worth when you have to leave all that cash in the bunker for safe keeping from the chance of getting put to? I know that it can indeed be worth it in times of big volatility.

 

Could somebody enlighten me with some examples?  :-\

[bcvaluation]

I keep about 25-30% in cash so that I have some buying power if/when then market takes a dive.  However, I have found that keeping this much cash at the ready creates a ton of drag on my returns. I was exploring methods of getting a decent return on my cash. 

 

What do you do to prepare to take advantage of when stocks drop into rock bottom sale prices?

[TwoCitiesCapital]

This might be a silly question and comes from someone with no experience of options - just starting to learn  :).

 

What I haven't been able to visualise in my head as of yet is; why would someone leave that cash pile just sitting there doing nothing? Yes, you earn the premium and can roll the options from period to period as an income stream, but there there must be surely a better way to get the most of your money? Is the premium really worth when you have to leave all that cash in the bunker for safe keeping from the chance of getting put to? I know that it can indeed be worth it in times of big volatility.

 

Could somebody enlighten me with some examples?  :-\

 

Because if you wait for volatile markets, you can make pretty high premiums.

 

A few months back I sold puts @ $7 on Blackberry when it was around $7.50 on it's way down from $9+. For a contract that had six weeks left until expiry I was paid $0.50 per share ($50 per contract) for risking $700 for 6 weeks.

 

That's a 7% return in 6 weeks. It's hard to imagine finding better opportunities than that. Wait for attractive premiums and sell the contract and if it goes well then you've covered the opportunity cost of that cash for the entire year with a single trade. If it doesn't go well, your cash gets put to work at a lower price than it would have if you had purchased the stock outright.

 

 

[philippoc93]

This might be a silly question and comes from someone with no experience of options - just starting to learn  :).

 

What I haven't been able to visualise in my head as of yet is; why would someone leave that cash pile just sitting there doing nothing? Yes, you earn the premium and can roll the options from period to period as an income stream, but there there must be surely a better way to get the most of your money? Is the premium really worth when you have to leave all that cash in the bunker for safe keeping from the chance of getting put to? I know that it can indeed be worth it in times of big volatility.

 

Could somebody enlighten me with some examples?  :-\

 

Because if you wait for volatile markets, you can make pretty high premiums.

 

A few months back I sold puts @ $7 on Blackberry when it was around $7.50 on it's way down from $9+. For a contract that had six weeks left until expiry I was paid $0.50 per share ($50 per contract) for risking $700 for 6 weeks.

 

That's a 7% return in 6 weeks. It's hard to imagine finding better opportunities than that. Wait for attractive premiums and sell the contract and if it goes well then you've covered the opportunity cost of that cash for the entire year with a single trade. If it doesn't go well, your cash gets put to work at a lower price than it would have if you had purchased the stock outright.

 

Ye when you can get those sort of premiums, it definitely can cover the opportunity costs. Was your money at risk not only $650 though, $700 - $50 premium you received.

 

I don't know anything about Blackberry, but I take it that you didn't think you would be put to at $7, or if you were, you wouldn't have minded getting the stock at a reduced cost of $6.50?

 

Thanks for the reply btw

[TwoCitiesCapital]

This might be a silly question and comes from someone with no experience of options - just starting to learn  :).

 

What I haven't been able to visualise in my head as of yet is; why would someone leave that cash pile just sitting there doing nothing? Yes, you earn the premium and can roll the options from period to period as an income stream, but there there must be surely a better way to get the most of your money? Is the premium really worth when you have to leave all that cash in the bunker for safe keeping from the chance of getting put to? I know that it can indeed be worth it in times of big volatility.

 

Could somebody enlighten me with some examples?  :-\

 

Because if you wait for volatile markets, you can make pretty high premiums.

 

A few months back I sold puts @ $7 on Blackberry when it was around $7.50 on it's way down from $9+. For a contract that had six weeks left until expiry I was paid $0.50 per share ($50 per contract) for risking $700 for 6 weeks.

 

That's a 7% return in 6 weeks. It's hard to imagine finding better opportunities than that. Wait for attractive premiums and sell the contract and if it goes well then you've covered the opportunity cost of that cash for the entire year with a single trade. If it doesn't go well, your cash gets put to work at a lower price than it would have if you had purchased the stock outright.

 

Ye when you can get those sort of premiums, it definitely can cover the opportunity costs. Was your money at risk not only $650 though, $700 - $50 premium you received.

 

I don't know anything about Blackberry, but I take it that you didn't think you would be put to at $7, or if you were, you wouldn't have minded getting the stock at a reduced cost of $6.50?

 

Thanks for the reply btw

 

You can look at it two ways. Your are absolutely only risking $650, but it's hard to calculate returns from that sum because you've already assumed the maximum return and used it to reduce your amount at risk from $700 to $650. I prefer to think about it as the notional at the strike price ($700) and the premium is my return for accepting that risk - no different than when a stock pays you a dividend (you don't use it to reduce your cost basis, it becomes part of your total return).

 

As for my opinions on blackberry, it's been range bound for the last few years where $7 has generally been the low-end of that range. I sell puts as it approaches $7 and buy them back and sell covered calls as it approaches $9. If I get put to at a cost basis of $6.50, I don't mind owning the shares, but I'm not generally doing it to establish a larger position in the name as much as I am trying to generate a decent return on cash and the shares already owned.

 

 

[philippoc93]

Ye I guess I was making the implicit assumption that the option would expire worthless, but one might like to close out the position by buying the option back just to remove the remaining risk, thus lowering your return slightly. I like the way you compare the premiums to options. I hadn't thought of it that way, but it makes sense.

 

 

[Deepdive]

I've seen a few hedge funds blow up in 2008-2009. These are hedge funds with >15% CAGR over ten years and they blow up. Things work well until they don't. It feels like you're taking candy from a baby and one day you're forced to buy the stock. If selling puts is very attractive, going long on the stock is likely the better option.