The previous article might have intrigued you on my put selling strategy, so I thought it important to also share cautionary guidelines.
Before beginning such a strategy, an investor should have at least five years of successful stock investing experience, encompassing at least one bear market. If past success has been spotty, fixing basic stock investing skills must come first. The experience should encompass a bear market to understand your reaction. Put selling will increase volatility, both the up and down.
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Stick to solid, financially sound companies. Conservative companies unfortunately have lower option premiums because they are less volatile but have a better probability of recovery from a down market.
Stock selection is key. Only sell puts on companies you want to own at the current price. The premium can reduce cost by 10 to 15 per cent if you get put. If not, you keep the premium.
I usually sell puts as far into the future as possible. The premium, thus the stock discount, is larger the further out you go. I try to have options expire the third Friday of January, which is the biggest option expiry date, making management of contracts less onerous. My rare approach is evident as open interest, the number of contracts currently consummated declines the further out you go. For example, at time of writing there is open interest of 1513 contracts for a $200 put on 3M expiring October 15, 2021, but only 81 for January 20, 2023. The bid is $7.10 for the two-month-out contract and $25.65 for 17 months out. I would sell the latter.
Keep the underlying value of a position similar in size to other holdings in the portfolio. This is important. If a portfolio has 20 stocks with holding sizes between $5,000 and $20,000, keep the notional value of any individual put sale below $20,000. This would be two contracts of shares worth $100. That’s the max. It is very easy to overextend, which can be trouble if things don’t go as expected with the company.
Put selling uses margin. Monitor margin levels closely and keep a cushion. My newsletter account often used maximum U.S. margin but very little Canadian. It’s total margin that’s important. That’s how I built equal-sized USD and CAD portfolios without converting much CAD to USD.
Be prepared to add cash in an emergency such as the COVID crash. Otherwise, you might have to unwind positions at a bad time. Sticking rather than folding during tough times is critical.
Why the strategy works
That’s a good list of blunt warnings, so let’s look at why the strategy works.
Since 1926, the S&P 500 index of the largest U.S. companies has been up greater than 12.5 per cent 49 out of the 95 years, or just over half of the years. It has been up between zero and 12.5 per cent 21 out of 95 years or 22 per cent of years. It has been down between zero and 12.5 per cent 18 out of 95 years or 19 per cent of years, and it has been down over 12.5 per cent only 7 out of 95 years, or about seven per cent of the time.
If I sell puts on companies that perform equal to or better than the market, and achieve an average of 12.5 per cent option premium, the strategy will work when the market is up 70 out of 95 years. It will be break-even the years the market is down a little, representing 18 of 95 years, and will only be a significant losing strategy seven per cent of years, when the market is down a lot. The great thing when the market is down a lot, it’s usually up a lot within a year or two so just hang on. A strategy that works 74 per cent and fails seven per cent will be profitable if wits are maintained during difficult periods.
That’s my theory. In practice, since starting the newsletter account, I have sold 56 put contracts that have passed their expiration date. Twenty-nine of the contracts have expired worthless, profiting the entire premium. I purchased 18 contracts back profitably, and one at a loss. I had eight stocks put to me, two of which I sold at a loss and six that I still own, of which, only two are currently in a loss position. That’s 51 to 5. Out of 14 put option contracts set to expire in January of 2022, eleven are currently profitable and three are in a loss position.
This record propelled the portfolio to a 140 per cent gain in four years, four months, time weighted. While very few promises can be made with stock and option investing, I can guarantee my record going forward will not be as good. When’s the last time you heard that from a market newsletter writer?
