I frequently sell puts. This has helped me build the U.S. side of the taxable portfolio I publish in my newsletter from US$37,405 four years ago to US$90,000 today. Over these years I have been put once, had 14 positions expire and have profitably bought out an additional 11 positions. My profits have totaled $29,000 from all put contracts completed to-date.
This illustrates the potential for success, but selling puts is still risky. It employs margin, providing torque to the upside but also increasing downside volatility during market declines. Investors should not attempt to buy or sell options until they have achieved significant success with stocks, and remain mindful: the only folks that don’t make mistakes are six feet under. For those who are ready, I’ve developed some simple guidelines to de-risk selling puts.
1. Careful evaluation: I only sell put contracts on companies or exchange traded funds that represent good value. When selling a put I take the same evaluation approach as when I’m buying a stock, as I may end up owning it.
2. Small positions. I keep the underlying value of the stock represented by the put in line with the position size of other stocks in my portfolio. If my average stock holding is $15,000, I might sell one contract of a $150 stock, two contracts of a $75 stock or five contracts of a $30 stock (each contract represents 100 shares). Many fail at options because they make their position size too large. Several diversified small positions are safer than a few large ones.
3. Stable companies. I sell puts on large, stable companies that are unlikely to go broke. The option premium is less on these companies, but the likelihood of success is better. Larger companies have more liquid options and smaller bid/ask spreads. If the spread is too wide I usually don’t bother. Liquidity is important if there is a need to buy out the contract.
4. Longer expiry dates. I sell put options as far into the future as possible, doing thing differently than other market participants. Option time premiums increase the further out the expiry date. January is the biggest option month, so I focus on that expiry date to make management less time consuming. The longest option time period is just over two years, so options expiring in January 2022 are now available on larger companies. Smaller companies only have shorter-term contracts as these are more frequently traded.
Choosing options that expire a year or two into the future often gives me a 10 per cent or better discount off the current stock price when I sell a put. This level of discount is not available with options close to the expiry date.
As usual, I do things differently than most market participants.
5. Keep cushions. Selling puts will use margin in your account without incurring interest charges. Keep a reasonable margin cushion so you are not forced to buy back contracts during short sharp panics.
I also like to keep a little cash cushion in case I am put a stock unexpectedly. Generally, options are only exercised close to or at expiration, but a put buyer has the right to do it anytime.
6. Market focus. Most of my option trades are in the US which has a significantly larger and more liquid market, larger companies and broader diversification than Canada.
7. Sell and hold. I don’t trade frequently. My intent is to sell the contract and wait for expiration as I don’t want options to become a daily task. As with stocks, overtrading leads to almost certain failure. Interestingly while options are considered short-term securities, my average option-holding time is about a year and a half, twice the average holding period for stocks.
As with many aspects of farming or investing, employing a long-term strategy with a consistent approach is the key to success.