Building a position with Options – Selling (Writing) Puts
You are familiar with our universe of stocks, the stocks you watch and decide to enter when appropriate. What’s the best way to enter a stock? From previous lessons we learned timing is almost irrelevant. A random entry is as good as any other entry using sophisticated signals or technical analysis. I have also mentioned a common sense rule of not entering a stock when it is declining, who knows, it could go down a lot more yielding a better entry price. But, is there yet a better way still of entering the stock?
If you are building your portfolio, options are perfect, but remember, options are done in 100 share blocks, so don’t overdo options and stay consistent with the maximum number of shares you should own in any individual stock.
What do we accomplish by selling a put to enter the stock? 1) We get to earn income while waiting for the price we want; 2) we get to buy the stock at a lower price.
What are we doing when we sell a put option? We are telling the buying of the put option that we will buy the stock at a set price (we choose) on a fixed date (we choose). In essence, we are offering insurance to the buyer of the put option. And, like all insurance, the buyer of insurance pays the seller of insurance a premium. With this in mind, you are agreeing to buy the stock at that price so your broker will require that you have money in your account to cover the stock purchase. This money is tied up.
Another advantage of buying the stock thru the option is commission. When the stock is “put” to you, you only pay the commission you paid for the option, not the stock that is assigned to you.
The most important thing you need is a belief that the stock will go up. That’s why we only sell puts on stocks from our universe of momentum stocks. Stocks that have proved they have the ability to rise and hopefully will continue to rise.
The stock runs. What if you want a stock that is trading at $20 and you write a weekly option put at $19 for $0.30. At expiration the stock is trading over $19, you keep the $0.30, and you do not get to buy the stock. What if it jumped suddenly to $24? You missed out on $4 of gain for a measly $0.30, but you did make money.
The stock falls. Now, if the stock closes below $19 you are obligated to purchase the stock at $19, even if it fell to $15. In this case you are only underwater by $3.70 (strike – stock price – premium paid = $19 – $15 – $0.30) instead of $4.
The price, or strike you sell the put at, depends on your objective. Are you looking to earn income or enter a strongly trending stock? With our momentum universe it is probably a little of both. Personally, I am mainly interested in income. So far, in 2016, the S&P 500 has gained 6.36% which is on pace for an 8.5% annual return. Historically, since the most recent market recovery Sep 2010 to Sep 2016, the market has averaged 13.87% (dividends reinvested) annually. Going back to 1928 the market has averaged 10%.
My goal is to maintain an average return of 20%. This means that the premium paid must annualize to at least 20% for me to consider the option. The other qualifier I add is that I demand at least an 80% chance of NOT being forced to buy the stock. Remember, these trades are for earned income.
How do I know the odds of the stock being put to me? Your trading platform tells you. Every stock has a “implied volatility – IV” which is the estimated volatility of a stock. Generally, this increases in a bear market and decreases when the market is bullish. Remember, this is a prediction of future prices and like all estimates they are most accurate when predicting a short time frame and less accurate for dates far in the future. For this reason, I use these estimates for weekly options.
Think or Swim has a probability analysis chart which predicts prices over time based upon its IV. Below is the chart for NVDA as of Sep 23, 2016. This chart shows the range of prices that NVDA ($64.99) should be trading within on different dates with a 68% (1 standard deviation) probability. On this chart, according to Think or Swim, there is a 16% chance that NVDA will be below $62.28 on Sep 30, 2016. In another words, there is an 84% chance that the option expires and I keep the premium without buying the stock.
Looking at an option chain we see that the current premium on Sep 30 for a $62.50 NVDA option is $0.19, which is only about 15% annual return. This trade is a pass.
The same chart for another stock, LNG ($43.54), gives a lower price of $41.32 and the current put premium at $41.5 is $0.22, which equates to a 26% annual premium. A buy. There is a one standard deviation chance of never being assigned the stock and I am paid 20% + in annual premium for the risk.
Why does LNG give us a trade and NVDA doesn’t? It’s the IV. As of today, NVDA has an IV of 27.5% and LNG has an IV of 34.4%.
Buy Low, Sell High
From our prior lesson you learned that the option price is determined from its intrinsic value (IV) and time value (TV). IV is the difference between the stock price and the strike price. TM is the extra money built into the option price due to time. The most significant factor in determining the time value is volatility. The higher the volatility, the higher the option price.
Due to the relationship between volatility and time value, we want to sell high volatility. If we were buying calls or puts we would want to buy low volatility due to the lower premiums. This volatility changes over time, so while it may not be a sell today, tomorrow or next week could change. This is why we sell weekly options on high volatility stocks. But, only stocks from our stock universe!
Here is my Interactive Brokers list of stocks with weekly options in our stock universe. I have sorted the stocks by IV. IV ranges from a high of 64% to a low of 15%. Next to the IV column is the Chg% column which is the price change today. Generally, we want an IV over 30% and the stock should be trading positive for the day. Using that criteria our potential trades today are: AMD, TCK, S, P, and YELP. I actually sold puts today in TCK and YELP.
REAL LIFE EXAMPLES
Here are two real life examples from my personal account.
I started playing NVDA on 8/4/16 for this newsletter. I bought stock shares twice and sold the shares twice with covered calls. Meanwhile, I continued selling puts every week hoping to capture earnings and catching NVDA on a pullback. How did I do?
- Start price on 8/4/16 = $56.89
- Close price on 9/23/16= $64.95
This equals a buy and hold profit of $8.06 or 14.17%. Not bad for less than 2 months. How did I do with options? I last sold the stock on 9/16 at $61.5 when it was called away from a covered call. But, my total profit from holding the stock and options was $11.83 or 20.79%, a 47% improvement over buy and hold.
I first began trying to purchase MU on 8/29 with puts. I was never able to purchase stock, but I did collect premium almost every week. How did I do?
- Between 8/29 and 9/23 MU rose from $16.91 to $17.46 for $0.55 or 3.25% in less than a month.
- My option premiums during this time totaled $1.17 or 6.91%, a 100% improvement!
So, in summary, we want to sell puts to enter our trades. All we really care about is making money over time and beating our benchmark, the S&P 500. With the S&P 500 as our benchmark we would like to earn 20% or more annually.
Look for high volatility stocks from our momentum stock universe and sell puts to collect premium. If, the stock gets put to us, we just obtained our stock at a great price, otherwise we are paid to sit on the sidelines. If the stock is assigned to us, we can either ride it up or sell a covered call, again at 20% or more annually.
If you are just looking to earn premium, choose a strike one standard deviation below its current price. If you really want to get into the stock, choose a strike near or at the current price.
James Krider, MD
Dr. Krider is a practicing family physician in Apple Valley, CA. Dr. Krider is also a licensed insurance agent in the states of California (0I65488) and Nevada specializing in Medicare Advantage and Life insurance, an important aspect of wealth planning.
Dr. Krider is an Investment Advisor Representative licensed in the state of Nevada and is President of Krider Wealth Management, an Investment Advisor corporation in Nevada.
These comments were prepared by James Krider, MD, an investment advisor representative of Krider Wealth Management, LLC, a Nevada state registered investment advisor. The information herein was obtained from various sources believed to be reliable; however, we do not guarantee its accuracy or completeness. The information in this report is given as of the date indicated. We assume no obligation to update this information, or advise on further developments relating to securities discussed in this report. Opinions expressed are those of the advisor listed as of 9/23/16 and are subject to change without notice. Opinions of individual representatives may not be those of the Firm. Additional information is available upon request. The information contained in this document is prepared for general circulation and is circulated for general information only. It does not address specific investment objectives, or the financial situation and the particular needs of any recipient. Investors should not attempt to make investment decisions solely based on the information contained in this communication as it does not offer enough information to make such decisions and may not be suitable for your personal financial circumstances. You should consult with your financial professional prior to making such decisions. PAST PERFORMANCE SHOULD NOT BE CONSIDERED INDICATIVE OF FUTURE PERFORMANCE. ANY INVESTMENT CONTAINS RISK INCLUDING THE RISK OF TOTAL LOSS. This document does not constitute an offer, or an invitation to make an offer, to buy or sell any securities discussed herein.