I finally sold my first short put yesterday! As a reminder a short put is when you take on the risk of having to buy 100 shares of a particular company, at a particular price in exchange for an immediate premium paid to you in cash. This can either be done in a covered way (i.e. you have enough liquid cash with your broker to cover the shares being ‘put’ to you) or naked (your broker has enough faith that you’ll pay the trade). It took me a few weeks, and I had to change from Fidelity to TD Ameritrade, but I was approved to do naked short puts.
The specifics of my trade is that ADM will not go beneath $38 by August 19, 2016 in exchange for a $21 (.21 price x 100 shares) paid up front. First and foremost (and this is vital for my risk tolerance) I would not be upset if the stock was put to me. ADM is a dividend champion with decades of dividend growth history.
Applying my Short Put Option Methodology
I Will Only Buy Naked Puts on Those Stocks that Have Already Passed my Stock Screen
My stock screen criteria is:
- The company needs to have increased its dividend for at least 20+ years;
- The company needs to have a P/E less than 20 and it has to be less than its industry average;
- The company needs to have a greater operating margin than its industry peers;
- The company needs to have a price to book of 4 or less (and if more than 4 then it has to be less than its industry average);
- The company needs to have a dividend yield of at least 2.5%; and
- The company needs to have a dividend pay out ratio of less than 60%
When I first wrote my methodology I stated,
I am well aware that “directive #1” will limit my the volatility of the stocks I am researching (probably the reason I like the screen so much), and that, in turn, will minimize what I can get out of this strategy. I am comfortable with that, as this is just an “add on” to my dividend growth strategy.
Wow, was I right. I had to loosen my standards if I was going to find anything worth selling. So, I started looking at those stocks that survived just the first leg of the screen (i.e P/E). If I am getting put a stock at least I know it’s P/E will be in line with my goals and objectives to find undervalued stocks. I am keeping an eye at the rest of the metrics but with a less stringent eye.
The Strike Price Will be a Price that Has only been hit a handful of Times on a Multi-Year Chart
It is my goal to collect the premium and not actually get stock put to me, so it would seem prudent to choose a price that has rarely been hit.
It is hard to tell but that dip was 6 – 7 months long. I’d be happy to own the stock for a couple months, collect dividends and sell covered calls. In addition that big drop took 20 or so days to occur, so it is not like that happens over night.
I Will Only Risk 50 to 75% of my Current Capital on Margin
This is a bolt-on strategy to increase returns/income, and as such, I can’t even imagine waking up to a margin call from fidelity where they are demanding me to fund my account with additional capital (versus having to, reluctantly, sell positions).
My Account is worth approximtly $12,000 (with this crazy run up recently) – this would force me to buy $3,800 worth of AMD ($38.00 x 100). With no other open positions I am way below my self imposed ceiling.
I will Spread out the Expiration Date
In an effort to further minimize risk I am going to use multiple expiration dates instead of concentrating on one date. I think Directive #4 will allow me to avoid a broad market sell off and being put with multiple new positions. I think I am looking at a rolling 30 to 60 day option contracts.
Since this is my first sale there is nothing to spread out!
All Premiums Received will be Reinvested the Following Month
I owe my dividend growth stocks an additional $21 in purchases next month!