A Brief Primer on Options: Part 3 (Two ways to enhance your dividend growth portfolio with cash-secured puts)
April 17th, 2013 | 20 Comments
In part one, we discussed what options are and why you might want to use them. In part two, we discussed how to read an options table as well as how to open and close option positions. Now that we’ve made it to part 3, we’re going to look at two ways that you can use cash-secured puts to enhance your dividend growth portfolio. Cash-secured puts are my flavor of options, and after reading this, they might become yours as well.
Before you can begin leveraging the power of cash-secured puts, you need to remember that you must have an amount of cash in your brokerage account equal to the price of 100 shares of the underlying security. This is because each option contract controls 100 shares of the underlying security.
So if you want to write one put option against stock XYZ with a strike price of $40, you need to have $4,000 available in your account. If you want to write two put options, you need $8,000 available.
When writing an option, you get to pick which month you want the option to expire in. The option will expire on the 3rd Saturday of that month. As my own personal convention, I consider short-term options to have 1-3 months until expiration, and long-term options to have a year or more.
Use short-term puts as an alternative to limit buy orders
If you have done any investing before, you are probably familiar with the limit order. With a limit order, you place an order to buy a given stock at a pre-specified price (the limit). If the price of the stock drops below your limit, the stock is purchased. You may set the limit order to expire any time from the same day the order is placed until several months later. While the limit order is in effect, your cash is locked down by the brokerage to pay for the stock should it reach the desired price while the limit order is in effect.
That’s almost the exact same thing as a cash-secured put, except that with the put, you get paid a premium for keeping your money locked up.
For example, Coca-cola (KO) is trading at $36. You are willing to buy KO at $35. There are two short term puts expiring in 3 months that you could elect to use to make this purchase.
- A $35 strike for $1.20; If assigned, your cost basis will be $33.80 ($35 – $1.20)
- A $37.50 strike for $2.50; If assigned, your cost basis will be $35 ($37.50 – $2.50).
If you choose the $35 strike put, the stock must drop to below $35 by the time of expiration in order for you to get the stock. If you don’t get the stock, then you get to keep the $120 premium regardless (a 3.4% return in 3 months).
If you choose the $37.50 strike put, the stock must remain below $37.50 in order for you to be assigned the stock. If you don’t get the stock you get to keep the $250 premium (a 6.6% return in 3 months).
If you choose to sell the lower priced put, you have less chance of being assigned the stock, but if assignment happens, your final cost basis will be lower than the $35 you were originally willing to pay for the security outright.
If you choose to sell the higher priced put, you have a much better chance of being assigned the stock and you have a better rate of return on your investment. Of course, if you elect to sell the higher priced put, you must have an additional $250 available to be secured.
Use long-term puts as a bet that the stock price will rise
In this scenario, you think that a stock is likely to rise in value over the life of the option. There are two ways that you could capitalize on this situation. First, you could buy the stock as you would in traditional investing. Second, you could write a cash-secured put against the stock.
If you could just buy the stock, why would you ever want to sell a put which you do not intend to use to obtain the stock? The answer is that by selling the put, you can create a win-win scenario.
To begin constructing our win-win scenario, we need to start with the underlying security. I would not write a put against any stock that I would not be interested in owning. So you can imagine that most of my puts are limited to dividend growth stocks that have passed some basic screening procedures. Furthermore, you’ll want the stock to have a good chance to appreciate, so try to time writing your puts to periods when your chosen security is near it’s 52 week low or during a market downturn. By choosing severely undervalued stocks you will be able to reduce (but never eliminate) the chance of being assigned the stock.
Let’s say that you particularly like Coca-Cola (KO) and think that it’s going to rise over the course of the year. Currently, it’s trading for $36 per share. You decide to sell a put for $3.95 per share that is scheduled to expire in a year. $3600 of your cash is secured for the put, and you receive a $395 premium. $395/$3600 = 10.9%. That’s right, you just pulled in a 10.9% return on your investment by selling the put.
The first win scenario. Let’s say that the put expires worthless, or that you eventually buy it back for less than you paid for it. The money ($3600) that was secured is now free once more and you get to keep the premium ($395) that you received.
The second win scenario. You guessed wrong and KO eventually drops below the strike price and you get assigned the stock. Your $3600 is now gone, but you have 100 shares of KO in it’s place and you still get to keep the $395 premium. Your cost basis for those 100 shares is $3600 – $395 = $3205. While this may not have been your preferred outcome, so long as you selected a quality stock to serve as the underlying security, it’s not a bad outcome.
How much of your portfolio should you allocate to puts?
This is kind of a matter of personal preference. There’s no reason why you couldn’t build your portfolio solely through the use of long-term puts. If you happened to be unlucky enough to get assigned the stock, so be it, you wound up with a quality dividend growth stock.
I am on the conservative side by nature. My personal preference is to limit my long-term puts to 10% of my portfolio.
If funds are available, I will use a short-term put in place of a limit order provide that I can at least break even after commissions. If I don’t have enough funds to purchase 100 shares, I’ll use the traditional limit order.
Disclaimer: I am long KO. I am not planning KO related options trades at this time.
Readers: Do you use cash-secured puts to enhance your investment returns? Do you have any advice for people who may be interested getting started with puts?
Written by myfijourney
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