Seasoned investors with options trading experience can reduce their acquisition costs and increase portfolio returns by writing naked puts on the stocks they want to own. This strategy has been used for decades by investors, and in 2019 the economics supporting a systematic put selling strategy were confirmed in a study commissioned by the CBOE and conducted by Wilshire Analytics.
Wilshire compared the risk/reward profiles of five option-based indexes (on the S&P 500) to those of asset classes typically found in investor portfolios. They concluded that options generally improved risk adjusted returns compared the unmanaged index. Importantly, one strategy that employs put selling was almost always the best performer among those they followed.
Its risk/reward characteristics outperformed in nearly every type of market environment. And while duplicating an index and selling puts against it would be a difficult endeavor for the average individual investor, the basic concept of selling naked puts to acquire stocks at a discount is sound. With that in mind, let’s walk through an example to see the mechanics and some of the benefits of selling puts.
Setting The Strike Price
In this example, we want to own a stock that’s trading right around $160 a share. It has rallied recently and we don’t want to chase it. But looking at the chart below, we can see that the recent rally has stalled, and the stock has pulled back a little from an overbought position. So where do we get in? Where do we set the strike price?
It looks like there’s some near-term support at 150, which was also a long-term level of resistance. So that looks like a reasonable place to set our target acquisition price at least from a technical perspective. Let’s also make the assumption the stock is also fundamentally sound.
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Synthetic Limit Order to Buy
Selling a put is akin to a synthetic limit order to buy. The reason for this is that the strike price “limits” what we’ll pay for the stock if it trades at that level. The difference between a limit order and a short put is that selling the put lowers our net acquisition cost. This is because we collect option premium.
If we set a limit order to buy this stock at 150, then our cost basis in it would be $15,000 if our order gets filled. By contrast, if we sell a 150 put and bring in $2.45 of option premium, then our basis in the stock would be discounted to $14,755 (150-2.45 x 100). More importantly, if the stock doesn’t trade to our “limit” price, and we don’t get filled, we still get to keep the option premium.
As long as our investment objective doesn’t change, we can keep selling puts over and over again until we get assigned. The more we can do this the lower our ultimate cost basis will be in the stock. But put selling is not just an effective way for a long-term investor to acquire shares at a discount. For the trader, it is also an effective strategy to profit from a bullish outlook on a stock.
Investing Rather Than Trading
The reason investors sell puts is to acquire shares they intend to hold. But for the trader who would be comfortable whether or not shares are assigned, selling puts can be a more conservative approach than long call strategies.
Selling puts has two distinct advantages. The first is that time decay is in the trader’s favor. In our example, the short 150 put will increase in value by $11.90, with each passing day until expiration unless the stock price falls below that strike.
The position also becomes more profitable as implied volatility decreases. This leads to two other important points about this strategy.
The first is that implied volatility creates great opportunities for traders. The CBOE/Wilshire study points out that implied volatility (IV) is almost always higher than actual (or historical) volatility (HV). What it doesn’t point out is that whenever IV and HV diverge, they always get back together.
So shorting puts when implied volatility is high offers the trader a high probability of success as it decreases and gets back in line with historical volatility. The second point relates to the buy and hold investor.
If volatility rises over the next decade, then a short put strategy should also be very profitable for those looking to buy stocks at discounted prices. The reason for this is that volatility is the chief determinant of option premium. The higher IV is, the higher premium will be. These higher premiums translate to bigger price discounts for those interested in holding a stock long-term.
Issues to Consider
There are a few things that investors should consider before engaging in a put selling strategy. The first is assignment risk.
While the whole point of the short put is to get assigned stock that will be held for the long haul, the risk is that after assignment, the stock could keep falling. The total risk is equal to the price paid for the stock. In fairness, this is a greater concern for the trader than it is for the investor. Still, in theory, the stock could go to zero. The next issue to consider is transaction costs.
Commissions and fees will be due on every trade. They should be factored into the calculation. If puts are rolled over and over to generate income, a portion of the return that premium income generates will be consumed by transaction costs. Continually rolling puts highlights the final issue investors should consider the opportunity cost.
If the stock doesn’t hit the strike price over a long period of time, then the odds are good that it has risen in value. When this happens, the investor may have to accept the fact that this fish got away.