by Jonathan Yates | January 23, 2012 9:25 am
With the Standard & Poor’s 500 Index off for another year, you should look to profit from the downward trajectory of the many thousands of individual stocks and exchange-traded funds that are “optionable” (i.e., that have options available to trade on them).
Traditional short positions (that is, shorting shares you don’t own), while potentially lucrative, are treacherous due to the unlimited liability and the orientation of the market being against these trades. However, a great way to realize profits – and instantly, at that – is through writing “covered put” options, which offer much more protection and flexibility than simply going short on a security.
Options give the buyer/owner the right but not the obligation to buy or sell a stock. This must be done on or before a date at a set price (the strike price). A put is an option to sell.
Most options expire, whether with value or without. Only about 15%-20% are ever actually exercised, which creates an ideal environment for option sellers/writers. Writing a covered put option entails shorting a stock and then selling your right to sell a designated number of shares of the security within a set period.
Establishing a covered put position is easy after clearance from your broker. As the holder of the short position, you must write (“Sell to Open”) one contract for every 100 shares shorted.
The ideal stocks for writing covered put options should be low-priced with a meek dividend, a strong short position, declining sales and earnings growth, low institutional ownership and negative analyst recommendations.
Tootsie Roll (NYSE:TR) is a prime example. At $24.33, it is low-priced, with only a 1.24% dividend. (S&P average is 2%.) Institutional ownership is under 40%, and the short float is 13.24%. (Note: A short float of 5% is considered troubling.)
Tootsie Roll trades on the Big Board (NYSE), so there will be an efficient execution of the short. With both sales and earnings growth down in the most recent quarter, Tootsie Roll now has the lowest mean analyst rating possible.
Some Ideal Industries for Put Writing
Other candidates for writing covered put options should be selected from industries that are out of favor with investors. In 2011, that included homebuilders, shippers, airlines and financials. Because about 70% of the movement in the price of a security is based on the direction of its sector, writing covered puts on these stocks and ETFs can be more rewarding.
When the stocks of companies in an industry are beaten down so low, as you’ve seen happen with airlines, shippers and homebuilders, using an ETF is much more lucrative and prudent for writing covered put options. ETFs also protect against losses from a stock being acquired or the board of directors deciding to “bust a short” with a share-buyback program.
At present, the short float on the SPDR S&P Homebuilders ETF (NYSE:XHB), is 16.53%. For the shipping industry ETF, Guggenhiem Shipping (NYSE:SEA), it is 8.84%. The short float for the SPDR S&P Bank ETF (NYSE:KBE) is 5.54%.
Writing a covered put option on a lower-priced stock like Tootsie Roll or an ETF like Guggenheim Shipping will result in higher yields. The lower entry cost allows for a broader portfolio. Writing near-month (or even weekly) options usually results in a higher return than writing long-dated stock options (i.e., those with an expiration date that is several months away).
There is also greater protection because the market can always move against a position over time. So, the shorter the time to expiration of the contract, the lesser the chance of having shares be “put” to you.
Making Money on Your Covered Put Positions
Another thing to keep in mind: The deeper in the money a covered put option, the more likely the covered option is to be exercised, the stock sold and a profit booked. That is how put options help to hedge a short position. (A put is in the money if the strike price is higher than the market price of the stock.)
Maximum profits will be registered when the stock or ETF closes exactly at the strike price of the put at expiration. However, that rarely happens. Typically, the put options will either be in the money or out of the money at expiration. (A put is out of the money if the strike is lower than the market price of the shares.)
When the underlying stock is dormant or it has declined somewhat, gains will be made at expiration of the contract on the profit on the puts written. Any profits from the ETF or stock falling in price that was shorted are also booked.
When the underlying stock drops below the strike price of the puts upon expiration, any gains in the value of the short shares will be offset by an equivalent rise in the value of the put. In this case, if the underlying stock falls in value beneath the strike price of the put options, the position will no longer increase in value.
By writing covered puts, you can generate monthly income through selling downside protection to other traders and investors. The entire short position established does not have to be written — only the desired number of shares.
A Few More Tips for Successful Put Selling
Some more tips for effective covered put writing: It is best to write options in high-volume stocks on the NYSE to minimize execution costs. Limit orders should also be placed with any options for additional pricing protection. In a stagnant or bear market (like we saw in 2011, when the S&P 500 was down 0.004% for the year), writing covered put options offers shareholders another way to make gains when the market as a whole is not returning any.
Jonathan Yates does not own nor has any plans to buy any of the securities mentioned in this article.
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