Selling Puts: The Overlooked Strategy

Selling puts is an optimistic strategy. You will profit if and when the stock's market value rises; even so, it is easy to forget this because so much emphasis is placed on calls. The incredible feature of options trading is that strategies can be devised to suit any type of market and any level of risk. Evaluate puts for their potential, and compare short put risks to the risk of long calls. Their profile is identical; the risks are far different.

Comparing short puts to long calls is only one of the comparisons worth making.
You may be well aware of the special risks involved in selling calls and may consider short puts to fit into the same risk category; this is a mistake. When you sell uncovered calls, a number of things can occur: The underlying stock could rise indefinitely, so that, in theory, risk is unlimited. Even when you write covered calls, you still face the risk of lost future profits because striking prices lock in the option seller to a fixed price in the event of exercise.

The situation is completely different when you sell puts. The put is the opposite of a call, so as a put seller, you hope that the value of the underlying stock will rise. As the stock rises, the value of the put falls, creating a profit. You also face the risk that the stock's market value will fall. In that case, you experience a loss; however, this loss is finite. The greatest loss possible, in theory, is zero, but a stock is unlikely to fall that far. A well-selected company's stock will have a limited likely range of market price; for example, while market value could fall below a company's tangible book value per share, it does not stand to reason that market price would decline far below that level.

Smart Investor Tip

Selling calls cannot be compared to selling covered calls. Short puts are always uncovered. However, risk is quite limited compared to uncovered calls because stock can decline only so far.

Even a drastic decline in a stock's market value has limited consequences for the put seller. The risk of loss is confined, realistically, to the price range between striking price and book value; that is the lowest reasonable price level. There is no guarantee, however, and the market has shown time and again that price levels are relatively oblivious to the intrinsic value of stock. In other words, the fundamentals serve as a valuable means for evaluating a company's long-term growth potential, but short-term price changes are unreliable; the fundamentals mean little in terms of pricing over the next few months. Short-term indicators are unstable for any purpose of analysis. The market can be viewed as having reliable intermediate and long-term trends showing up through indicators; but the short-term trends are highly chaotic and unreliable, and this is where option risks reside.

Tangible book value per share -- book value minus all intangible assets such as goodwill -- is a fundamental support level for the valuation of stock. It is today's financial worth, without considering any prospects for future growth. A popular investing concept, value investing, means just that. You will do better buying a company's value, not a stock's price. So when analysts publish a target range for a stock, it makes sense to question (1) how the target range was arrived at, (2) whether price targeting is based on fundamentals, and (3) how price equates to the company's long-term investment value.

The primary question a value investor asks is, "What could this company be sold for today if it were on the market?" Another might be, "If I owned this company, what would it be worth per share?" Upon analysis, you arrive at a reasonable value for a company; and by comparing this to the market value of the stock, you can gain a sense of whether it is undervalued or overvalued.

A put seller takes a reasonable position in assuming that book value per share is a fair support level for stock price, and that the stock's price will not be likely to fall below that level. So a stock selling at $50 per share with book value of $20 per share could be assessed at having a maximum risk range of 30 points.


A Finite Risk Strategy: You bought 100 shares of Xerox Corporation (XRX) and paid $14 per share. When the stock had risen to $17 per share, you sold a three-month put in the belief that the stock would continue to rise in value. Striking price was 19 and you received a premium of 2 ($200). Tangible book value per share at the time was $4.68 per share. Given these facts, your maximum risk was $732:

Purchase price of stock$1,400
Less: premium received for put-200
Net basis in stock$1,200
Tangible book value-468
Net risk$732

You sold this put because you believe that $19 per share is a reasonable price; given the premium of $200, the price upon exercise would be reduced to $17 per share, the value of the stock on the day you sold the put. This is one of several ways to use options as a form of purchasing additional shares of stock at a discount.

In this example, the "net risk" represents the risk if and when the company were to be completely liquidated. In other words, Xerox Corporation would have to sell all of its assets and settle up with its creditors, leaving stockholders with $4.68 per share. A put seller evaluates this as the maximum risk, but, realistically, the exposure is far less. The $200 return on a $1,400 investment (before annualizing) is 14.3 percent. Because the put expires in three months (meaning risk exposure only lasts that long), annualized return should be four times greater, or 57.2 percent.

A put is an option to sell 100 shares of the underlying stock, at a fixed price by a specific date in the future. So when you sell a put, you grant the buyer the right to "put" 100 shares of stock to you at the striking price, to sell you 100 shares. In exchange for receiving a premium at the time of your opening sale transaction, you accept the risk of exercise. You are willing, as a put seller, to buy 100 shares of the underlying stock even though at the time of exercise, current value of the shares will be lower than the fixed striking price.

Smart Investor Tip

It makes sense to sell puts as long as you believe that the striking price is a fair value for that company's stock.

As a put seller, you reduce your exposure to risk by selecting stocks within a limited price range. For example, if you sell puts with striking prices of 50 or less, your maximum loss is 50 points, or $5,000; that, of course, would occur only if a stock were to become worthless by expiration date. If you sell puts with striking price of 25 or lower, the maximum exposure is cut in half, to $2,500 per contract. However, the more realistic way to assess maximum risk is to identify book value per share in comparison to striking price. That gap represents a more likely range of risk, regardless of the stock's current market value.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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