It has been a month since I sold my first put, and I am absolutely hooked! As a reminder, selling a put is when I collect a premium today for the possibility that a stock will be put to me at a predetermined price should the buyer of the put wish to sell it to me.
There are a lot pictures that try to explain it, but for me an example is much easier. Let’s take Company ABC which is trading at $50/share. I sell a Put with an expiration date in a month that if the stock is trading at $45 or lower I have an obligation to buy 100 shares at $45 (1 option contract = 100 shares). For this contact I am paid a premium today that I can reinvest. So that gives us 3 possible outcomes in 1 month’s time:
- Company ABC is trading at $55/share and the contract expires worthless – I keep my premium and move on with my life
- Company ABC is trading at $45/share and I am now holding $4,500 worth of ABC.
- Company ABC is trading at $40/share and I had to pay $4,500 for $4,000 worth of ABC.
My Initial Thoughts about Selling Puts as an Investment Strategy
As is the nature with an investment strategy it will organically morph as time goes on, and with only one month under my belt I can already see it happening. It is isn’t a good or bad thing, but rather just a natural occurrence. When I first started I was intent on keeping it way too safe. In doing so I had a hard time even finding my first trade. However, when I let go of the reigns a little bit the opportunities started to appear through the forest.
I can see this type of investment style being in my life for a very long time to come. It provides a boost of income not otherwise available. In the month that I have open and closed approximately $100 worth of contracts (with some currently open). This $100 would not have otherwise been available for me to invest. I am well aware that $100 isn’t a lot of money, but it is the future growth and possibility that excites me! That $100 has since (or will be) reinvested into my regular boring dividend paying stocks, which will then allow me to leverage again and sell against those newly acquired stocks! And so on and on.
I created a 4 part test as a guideline to keep me discipline. I can see how this type of trading could get out of hand without self-imposed structure (and yes I have already broken them as the situation my permit).
4 Part Test to Selling Puts
I created a 4 part test that I follow each time I go to sell a put.
Part 1: Underlying Valuation of Equity
Since there is a very real chance that I may be assigned 100 shares, for my own nerves, I have to take some precautions. So over the past month I have come up with my own methodology as to whether I’ll sell a short put based on the underlying equity:
- The company needs to have a P/E less than 20; and
- The company needs to have at least a 2.5% yield; and
- The company has to have at least 5 years of dividend history; and
- The company has to have a payout ratio of under 50%
Part 2: Chart Test
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. I recently bought a few shares of Target, so lets use them as an example since we know it meets Directive #1. I am going to use the 3yr chart (you may have to zoom in):
There were only 3 times inside the past 3 years that Target dipped below $55 – $58, and as important, there was a bounce back within a year. So Directives #2 is that I am looking for those stocks left (from #1) that rarely dip to the strike price I’d be choosing and when it does there is a bounce back. So even if I am “put” a stock I have a fairly good feeling that at some point in the near future I can roll out (should I need to)…which leads me to Directive #3.
Part 3: Portfolio Risk Test
Before selling a put I check to see how much of my portfolio is already leveraged with the real risk of taking on 100 shares of the equity. If my portfolio was worth $10,000 and I already had sold two puts that could put me on the hook for $5,000 I know I would have some room as I am shooting for a constant 50 to 75% of coverage. I have already hit above 80 for short periods of time.
Part 4: Expiration Date Test
Again, I am trying to limit very real risk of taking on too many exercised puts at once, so I spread the expiration date as much as is possible. I’d rather take in a few dollars less and have it close on a different day.