Andy is moving from covered calls to put spreads. Find out how he does it, and what it’s doing for him
As you know, I like to sell covered calls on some of the stocks I own. This is a rare strategy that is not understood by many, so they call it risky. I’ve had a lot of practice selling calls these past six or seven years so I figured it was time to expand my skills in the business of options.
Over the past few months I’ve read, studied, thought and practiced on paper an even rarer strategy, called using put (credit) spreads on a select group of stocks. I sure don’t want you to think that put spreads don’t have risks, but then so does farming, getting up in the morning and owning stocks.
In his book Getting Rich with Options, Lee Lovell writes that put (credit) spreads are a favorite strategy among professional traders. Why? Because they reduce the need to be correct on the direction a stock is going to go. Plus, when you sell puts at a high price and buy a put at a low price, you reduce the amount of money we need to put up as margin money in our account. That lets you do two things.
1. It allows you to make cash money as long as the stock goes up or down a small per cent.
2. Second, since we use less margin money, you can either work with less money or with more stocks, which should reduce risk.
You need special approval from your broker to get involved in put spreads, partly because it does take more knowledge about the strategy and it does take some thinking. This is not a skill for anyone looking for a no-brainer strategy.
However, once you are approved and you understand the strategy you don’t need to own actual shares, so in that sense we reduce risk. In fact, in an approved trading account we could hold top of the line blue chip stocks or plain GICs, bonds or cash and still sell puts and then graduate to using put spreads.
Selling puts on stocks you do not own takes what I call put space or margin money. When we use puts we reduce how much cash we make per deal, but we also reduce the amount of put space or margin we need per deal.
Put spread strategy
Knowledge is quite rare about the put spread strategy but it is getting more common
The big risk with selling puts is that you need to be right on the direction the stock is going to go. In that sense, selling naked puts is a directional trade. If we sell a put on a stock we do not own, and the stock price goes up, the market value of the put we sold will go down and we can buy it back for less than we sold the put for.
For example, on a stock called Thompson Creek Mining (TCM) I sold a put last fall for April, strike price $4, and collected $1.10 per share while the shares were trading at about $3.20. As I’m writing, the shares are $4.14 and the put I sold for $1.10 now trades for $0.45 cents. So I can buy that put back and clear $0.65 per share. I do own TCM shares, but those shares are not tied to the puts. These are independent trades.
On another stock, RMX, last March I sold a put for July when the shares were $4. I collected $0.50 which sounded really good but this was a small cap stock and about two weeks after I sold the put (guessing the shares would stay flat or go up) the shares started to drop and the trading price of that put went from $0.50 to $1 by July when that put expired.
I can say that I wanted to see what would happen as the shares dropped but in fact I guessed the wrong way on that directional trade. I “got put” those shares which means I had to buy them for $4 in July.
That really wasn’t so bad because my actual cost was $4 minus the 50 cents I collected by selling the put — my final cost was $3.50. Tax loss selling kicked in by November and those shares got whacked down and are $2.50 as I write. I sold calls on those shares, strike price $3, for January and collected another $0.14 which dropped my cost a bit more.
I did get tired of waiting for the price to go back up so I sold 3,000 of the 4,000 shares I owned and lost a few thousand dollars. I did keep 1,000 shares and the January options expired. I will sell another call on those stocks — I’m quite sure I can work my way out of this loss by selling calls.
My main message is that I guessed correctly on the direction TCM was going to take so my puts will make money. But I guessed wrong on the directional trade for RMX and they cost me money.
Since August 2012 I’ve taken in well over $1,000 a month from selling puts with the correct directional trade but I lost $3,000 or maybe $4,000 selling puts when I guessed wrong on the direction on other stocks. So I’ve made many more thousands than I lost as I learned to sell puts on stocks that went up as we expected. I’ve made money selling puts on TCK.B, TCM and CUM.
Selling a put spread
Now I’m going to show you what I saw on January 21 when I tested the idea of selling a put spread on Bombardier (BBD.B).
The shares were trading at $4.14 that day. They appeared to be in an uptrend as the company was getting orders for its C-series of airplanes and it had just arranged a $2 billion financing plan to help pay for parts and labour needed to get the planes to market.
I needed to do two calculations. One was how much money I would tie up as put space or margin money. To do that I took the difference between the two strike prices and subtracted the difference between the bid and ask prices on the two premiums.
So, the calculation went like this: ($4 – $3) – ($0.24 – $0.09) x the number of shares. So ($1.00 – $0.15) = $0.85 x 5,000 share = $4,250. This is how much put space or margin money I would need to sell a put spread on 5,000 shares for July, strike price $4.00.
On the money side, I would sell an expensive put for $0.24 cents x 5,000 = $1,200 and buy the cheaper $3 put for $0.09 or $450. The difference would be $1,200 – $450 = $750, in cash. Based on the $4,250 of put space the return would be $750 divided by $4,250 or 17 per cent for half a year.
The premium is fairly low because I chose to sell a put at $4 while the price was $4.20 which reduces the risk that I will have the shares put to me. So if the shares stay above $4 between the day I made the deal and July expiry, I won’t need to buy the shares and the put I bought will just expire worthless.
If I thought I had the directional trade correct, I could just sell the put at strike price $4 and collect $0.24 per share ($1,200) but it would need more put space or margin money.
Looking at BNP
When I was buying BNP shares the dividend was $0.12 per share — $1.44 per year or around 10 per cent per year on a $14 to $15 stock. That was about $420 a month in dividends taxed at a preferential rate. The company cut the dividend to $0.07 per month — $0.84 per year or just over five per cent per year. That would be $245 per month.
Can I use a put spread to try and make up for the cut in dividends? Let’s see.
I could sell an expensive put at $14 strike for March and buy a cheap put at $13 strike. Here are the numbers.
($14 -$13) – ($0.45 – $0.25) x 1,000 shares is ($1 – $0.20) x 1,000 = $800. I would need $800 of margin money and I would collect a net of $0.20 x 1,000 shares = $200.
On a margin of $800 that is a return of 25 per cent for two months, or $100 a month. It doesn’t quite make up for the drop in the dividend unless I work with 2,000 shares.
I have the margin room but since I already own a big batch of shares I’m not sure I want to buy more.
Using put spreads can make you money. It took me a while to get the strategy through my brain, but it also took a while to find someone who could explain the strategy to me so I could understand it.
Several readers now use put (credit) spreads to pick up extra cash and I will too. I prefer to just sell puts when I’m sure of the direction shares will go, but I can be wrong and just selling puts uses up a lot of margin money or put space. Selling the expensive put and buying the cheap put reduces profits but also drops the margin you need for the deal. †