May 11th, 2021
By: Steven M. Sears, President, and COO
Just like how a covered-call strategy can enable investors to potentially sell their stocks at above-market prices, selling puts can enable investors to buy stocks at below-market prices. The construct may seem confusing, and even a bit contradictory, but the sale of puts can better position investors to buy stocks at prices below their stock market value.
Say you want to buy a stock for $50, but the stock is trading for $65. You obviously like the stock, but you are uncomfortable buying the stock at $65, which is close to the stock’s 52-week high price. But if the stock was at a lower price, you’d buy. This is where the power of put options can help investors reshape stock prices.
By selling a $50 put, and choosing an expiration cycle within one to three months, an investor can essentially get paid by the options market just for agreeing to buy the stock at a certain price and within a certain time. Should the stock price remain above the put strike, an investor can keep the money received for selling the put. But if the stock price is at, or below, the strike price at expiration, investors are obligated to buy the stock at the strike price or to cover the put, or adjust the position.
It is for those reasons that investors must generally be ever mindful of the risks of selling puts to buy stocks at below-market prices. In general, only sell puts on stocks that you are willing to own, and that you can afford to buy.
Unlike a covered-call strategy where the call option is securitized by long stock, there are generally two primary ways to securitize put sales.
Typically, an investor must either:
1. Set aside the money needed to buy the stock in either a money-market fund at a brokerage firm; or
2. Satisfy the margin requirements at a brokerage firm.
Let’s consider each funding scenario:
A cash-secured put sale is where an investor takes the money needed to buy a stock and deposits the money in a cash account at their brokerage firm. For example, an investor who wants to sell a put with a $50 strike price must have $5,000 in cash to be able to sell a cash-secured put. At expiration, the cash is either released or used to buy the stock.
Puts also can be sold in margin accounts. Margin rules often vary from broker to broker, but most firms require a 50% cash deposit into a margin account, and occasional maintenance margin payments should the stock price decline.
The Good Investor Rule
The stock market, as many believe, is a discounting mechanism: the prices of all securities reflect Wall Street’s assessment of what may happen to the companies in the future. In many ways, the stock market has become like the great library of Alexandria that was once filled with books and knowledge. Every stock ticker, and every flashing price, is filled with knowledge about what has happened to the company, and what may happen to it in the future.
Though the stock market tends to always look forward, it is arguably best understood by looking backward. The collective experience of investors is often one of volatility and tumult and great greed and at times even greater fear. What we have learned, collectively, and individually, is something we call the Good Investor Rule. It is a simple maxim that seeks to define how we use options as strategic investment tools to better navigate the stock market. To us, the rule expresses a timeless truth: Bad investors think of ways to make money. Good investors think of ways to not lose money.
The Good Investor Rule is our guiding principle. We use puts and calls in an effort to temper the volatility of our journey through the stock market. We use puts and calls in an effort to enhance income and to generate conditional dividends. What is the condition of our options-centric dividend? An investor must be willing to buy the stock at a lower price or to sell the stock at a higher price. In return, an investor can collect options premium.
Our goal is to strategically use puts and calls. We want to enhance income, and ideally reduce risk, while positioning to more effectively buy and sell stocks, exchange-traded funds, and indexes.
Our approach represents a commitment to a way of thinking and acting, as much as to a way of investing. Our goal is to enhance the long-term compounding engine of reinvesting stock dividends, with our conditional dividends from the options market. We think there is great merit in this approach, especially at a time when it is so difficult for investors to find investments that generate income.
We believe that if we can consistently enhance returns, and reduce risk, we will have done something meaningful, something that can change lives and improve financial outcomes in an area of people’s lives that is often challenging and confusing for many people. We readily concede that the approach will not always produce the desired results. Sometimes, the strategies may be overtaken by events that cause securities, and even entire markets, to behave in ways that were out of character, and thus unexpected. Such is the risk of investing that confronts all market participants, and that can impact all strategies, including ours. While we like to note that there is no free lunch – TANSTAAFL – we believe the contours of conservative options strategies present investors with reasonable risks.
In our view, a key to successful investing is understanding risk, and then defining risk in such a way that the risk exists as a fact to manage, and even monetize. This type of investing has long been the quiet purview of many of the world’s most sophisticated investors. Now, as people have learned more about the markets, and ways to invest, interest in options strategies is at historic highs insofar as options trading volumes are at levels never before seen.
The COVID-19 pandemic has shown that America is a nation of investors. We know now that many investors are interested in options, and thus we share our framework for conservatively using options, and our disciplines, in an effort to improve financial literacy and to help investors improve their decision-making so that their journey through the markets are more useful.