09/10/10 Selling PUTS

Selling PUTS

A reader of our blog asked us to comment on an article placed on the investing site Seeking Alpha. We exchanged a few e-mails and I thought it would be beneficial to share our thoughts with all our readers. The premise of the article was to sell PUT options for the income.

The idea is to find a stock you like, but are not prepared to own, then sell a PUT option on the stock for the income. Selling a PUT obligates you to purchase the stock at the PUT’s strike price. The buyer gets to PUT the stock to you at a predetermined price, the strike price, if they choose.

Example:

XYZ stock – spot price $25.00
Sell one - one month put option at a strike price of $22.00
Take in premium of $1.25

Your breakeven is $20.75 = Strike $22.00 – Premium $1.25

If XYZ stock trades above $22.00 you keep the premium and the stock is not put to you.
If XYZ stock trades below $22.00 but above $20.75 the stock may be put to you.
If XYZ stock trades below $20.75 the stock will be put to you.

The owner of the option, the person you sold the put to, can put the stock to you at any time prior to the expiration date.

If the stock is put to you, you are obligated and must pay $2,200.00 to the owner of the option.

The total cost to acquire the stock is $2,075.00 = Strike $2,200.00 – premium $125

The price of the stock at the time it is put to you will be less than the strike price of $22.00.

We do not particularly care for this strategy for several reasons:
1) It ties up capital – you need to keep and make sure you have the money readily available pay for the stock if it is put to you
2) If we like a stock we buy it – not much else to say
3) Loss of upside opportunity – if we like a stock it should have upside potential and not owning it means we have no participation in the upside
4) Vigilance of monitoring – the constant need to make sure there is enough money in the account, the plan of action if the stock drops suddenly, keeping the strategy in mind when making other portfolio decisions
5) Loss of dividend – if you do not own the stock you do not get the dividend
6) Obstacles – this is a “short sell” or “naked” strategy. As we posted in a very early writing we do not like anything with the word “naked” in it. Brokerage firms make it very difficult for investors to enter into any strategies involving these types of strategies and for good reason. Anyone employing this strategy must really know and understand the risks involved.

Generally speaking, we view the “naked” selling of puts to be a speculative strategy. We are investors not speculators. Although the risks inherent in this strategy are quantifiable, the rewards at this time do not seem to be attractive. This strategy is more attractive to us in a high interest rate environment where you are getting paid a reasonable amount of money to keep a cash reserve.