selling puts
TRANSCRIPT
- 1. Prepared by
Thomas A. McDevitt
Chartered Financial Analyst
Certified Financial Planner
May 2011
Selling Puts:Getting Paid While You Wait
2. Investor Conundrum-Part I
Many investors feel as though they missed out on the rebound in
equity prices from 2009 to the present.
3. S&P 500 Up 101.60% Off Of March 9th, 2009 Low
4. Only Fools Rush In
5. Danger Ahead?
Presently a high level of bullishness amongst investment advisors.
A historically low percentage of investment advisors expect the
market to go down. This should be viewed as a negative (the masses
are asses).
The CBOE Volatility Index (VIX) is at pre-crisis lows, indicating
investor complacency.
Stocks arent cheap anymore, as measured by Tobins Q.
6. Tobins Q
7. Investor Conundrum-Part II
As investors wait on the sidelines for a better entry point into
the stock market, they are earning a negative real rate of return
(interest rate earned less inflation).
Investors in cash positions are losing wealth with each passing
day.
8. Inflation:Somewhere Between 2.00% and 11.00%
9. 1.71% on a 5 Year Treasury
10. Cash is Trash
11. Selling Puts
One way to enhance cash yields and control portfolio risk is to
sell puts against equity investments.
This strategy is appropriate for opportunistic investors with large
portfolio cash positions who would shift from cash to stocks at
lower stock market levels.
As you will see, the strategy can be adjusted to accommodate all
types of investor objectives from the conservative to the highly
aggressive.
12. Selling Puts
When an investor sells a put without ownership of the underlying
instrument, he or she is agreeing to purchase the instrument at
some specified price on some specified date.
13. Selling Puts
Example
Jane likes ABC stock, but doesnt want to pay current market
prices.The stock is currently $100 per share.She would be
comfortable buying ABC if it hit $75 per share.
14. Selling Puts
Jane can call her broker and place a good-until-cancel order to buy
ABC at $75 per share.If the stock never trades to that level, Jane
will not be executed.
OR
15. Selling Puts
Jane can call her broker and agree to buy the stock at $75 per
share in January 2012.She does so by selling a January 2012 Put on
ABC with a strike price $75.The January 75 Put on ABC is trading at
$2.
Lets assume that Jane would want to purchase 1,000 shares of ABC if
it hit $75 per share.
16. Selling Puts
In return for selling the put, Jane will receive $2,000 today ($2
option premium xs 1,000 shares).The money gets deposited into her
brokerage account.This is her money to keep.
Janes obligation is to purchase shares of ABC in January 2012 at
$75.
17. Selling Puts
If ABC is above $75 per share on expiration in January 2012, Jane
will not buy the stock.The put simply goes away.
If the stock is $75 per share or less on expiration in January
2012, Jane will be required to buy the stock.1,000 shares xs $75 =
$75,000.
18. Selling Puts
Note that Janes cost basis in ABC will be lowered by the amount of
option premium collected.In this example, if Jane actually ends-up
purchasing the stock, her cost basis will be $73 per share.
$73 Cost basis =
$75 purchase price - $2 option premium received
19. Selling Puts
Since were interested in mitigating risk, lets expand the
example.Lets walk through an exercise in which we sell puts against
a broad basket of stocks instead of a single, standalone
company.
20. Diamonds
Diamonds (DIA, NYSE) is an exchange traded fund (ETF) that is
designed to track the performance of the Dow Jones Industrial
Average.
On May 27th, 2011, the Dow Jones Industrial Average closed at
12,441.Diamonds closed at 124.28.Simply move the decimal point over
two places to the left on the Dow Jones to come up with approximate
value of Diamonds (note, small differences will exist).
21. Diamonds--Holdings
22. Diamonds
Lets assume that Jane would enter the stock market if the Dow Jones
Industrial Average, which is currently 12,441, falls to
11,500.
What can she do other than keeping her funds in a low interest
bearing instrument?
23. Diamonds
A Dow Jones price of 11,500 is comparable to a Diamonds price of
$115 (Diamonds or DIA is presently $124).
Jane can sell a January 2012 Diamond (DIA) put with a strike price
of $115.The put premium on this contract is presently $4.15.
24. Diamonds
Lets assume Jane has $1,000,000 to invest in equities.How many
contacts should she sell?
$1,000,000 $115 = 8,695
In return, Jane will receive $36,086
- 8,695 options xs 4.15 option price
This is Janes money to keep.
25. Diamonds
Janes obligation is to buy the Dow at 11,500i.e., DIA equivalent of
$115if in fact the Dow is at or below this level in January
2012.
If the Dow is > 11,500 in January, the option will expire.
26. Diamonds
Note that Janes cost basis in the Diamonds will be the purchase
price of $115 less the option premium received of $4.15 or
$110.85.This is comparable to buying the Dow at 11,085, which is
approximately11 % below current market prices.
27. Diamonds
Note that selling puts against the Diamonds has the effect of
buying on weakness, which is a concept we all learned in
kindergarten (buy low, sell high)!
28. Diamonds
No brokerage firm will permit an investor to sell puts without
putting up some cash.
To simplify the example, lets just assume that Jane puts up her
entire potential commitment of $1,000,000 when she opens a
brokerage account;she places the funds in an 8-month CD yielding
.70%.
29. Diamonds
Ending Value of Account if Dow > 11,500 in January 2012
Beginning Value:$1,000,000
Put Premium Collected:$36,086
Ending Value of CD:$1, 004,666
Ending Value of Account:$1,040,752
Holding Period Return:4.08%or 6.12% annualized
30. Pulling It All Together
Smart, logical, and hesitant investors face a conundrum.Stocks have
risen sharply off of their March 2009 lows AND interest rates
remain at historic lows.
Selling puts against the Dow Jones Industrial Average is a
disciplined way to enhance cash yields while waiting to invest
money in the stock market at substantially lower levels.
31. Are There Risks?
OF COURSE!
In the above example, the Dow Jones Industrial Average could be
below 11,500 in January 2012. When Jane takes possession of the Dow
(DIA) at $115 in January 2012, she would have an unrealized loss
equal to:
Strike Price Option Received Prevailing Dow Prices
But remember, the cost basis is reduced by the amount of premium
collected.So Jane would be most interested in seeing the Dow close
above 11,085, as previously illustrated.
32. Are There Risks
And also remember that the investor can control where he or she
wants to enter the market.The investor controls the degree of risk
to be assumed!More conservative investors would select a lower put
strike price (say Dow Jones 10,000).More aggressive investors would
select a higher put strike price (say Dow Jones 12,000).
33. Are There Risks?
And, also remember, that a 100% cash position is actually
destroying wealth!
And, selling puts against the Dow with strike prices at
substantially lower levels is actually more conservative than being
100% long at current market prices!
34. Selling Cash Secured Puts
Increases yields on cash only instruments (CDs, Treasurys, Money
Markets, etc.)
Gives investors a disciplined way of buying low
Has lower risk than an all-equity portfolio with exposure to
prevailing market prices
35. Call Tom McDevitt Today at 215-990-0781 to Schedule an
Appointment!