by Karim Rahemtulla, Options Expert
Tuesday, June 22, 2010: Issue #1286
Did you “sell in May and go away?”
Many investors did, sending the Dow Industrials down 872 points for the month.
And although the index has put together a nice 8.1% run since the June 8 low, it’s still got a way to go before it approaches its 52-week high of 11,309, set in late April.
So what did you do while the market was selling off? And what will you do during the next one?
The answer is simple: Embrace your ugly stepchild – put-option selling! Allow me to explain…
Put-Option Selling: From Ugly Stepchild to Prom Queen
Misunderstood and often snubbed for allegedly being too complex and risky, put-option selling is like the ugly stepchild of options investing.
But no matter what mood the market is in, used correctly, put-selling can actually be your portfolio’s prom queen. It’s particularly attractive when the market is in the throes of a correction, which is exactly why I highlighted put-option selling during the market’s sell off in May.
And if you need further convincing, it’s worth knowing that savvy investors like Warren Buffett engage in put-selling without blinking an eye. Why is that? Is Buffett getting senile? Does he think he’ll lose money on the strategy?
A resounding “no” on both counts. It’s because put-selling works.
However, there’s a right way and a wrong way to execute the strategy. So make sure you understand the difference before you invest…
The Right Way and the Wrong Way to Put-Option Selling
When you sell put options on a stock, you’re obligating yourself to buy the shares at a pre-determined price (the strike price) – and a tidy discount to the current share price.
However, you’ll only be asked to fulfill that obligation if the stock closes below the strike price at options expiration. And you’ll be required to buy the applicable number of shares in relation to the number of options contracts you sold. For example, if you sell one contract, you’ll buy 100 shares… two contracts = 200 shares… three contracts = 300 shares… and so on.
For taking this obligation, you’re paid cash immediately (the option premium) that is yours to keep, regardless of the outcome. In short…
~ Put-Selling Done Right: When executed the right way, put selling is a win-win. Here’s why…
- When you sell a put option on a stock, you have a chance to buy the shares at the price you want (a discount) if the stock closes below your strike price at expiration. And who wouldn’t want to buy something at a discount?
- For implementing the trade, you receive instant cash into your account. And who wouldn’t want that, either? If that risk works in your favor, you keep the cash completely free and clear with no obligation at expiration.
- You tie up a fraction of your capital – 20% to 30% of the underlying share strike price – for the opportunity to own the shares.
- Your return on investment is magnified since you’re only tying up a fraction of your capital.
~ Put-Selling Done Wrong: If you sell puts just to “chase” the premium, you’re missing the point of the strategy. Receiving the premium is just one element of the trade. By aiming solely to grab as much premium as you can, it means you’re just trying to get money from the market and hoping the shares don’t get “put” to you because you have no intention (or no money) to buy them. A big no-no!
Four Tips for Perfect Put-Option Selling
The bottom line is that a put-selling strategy is fertile ground – especially in this market.
Here are some put-selling tips…
- The best time to sell puts is when the market is very volatile and when it’s correcting. Both usually occur concurrently. This is because volatility increases options premiums, so you receive more money during volatile periods. Plus, when the market is correcting, you can sell puts well below the current share price and still collect lots of cash.
- Only look at high-quality, blue-chip companies.
- Only sell puts at strike prices between 20% and 50% below a stock’s current price. This provides additional cushion during a downturn.
- Only sell puts on companies that you truly want to own.
If you follow these simple rules, embracing volatility with a put-selling strategy can energize any portfolio in any type of market.