Cash burning holes in your pockets? Tired of waiting for a crash to materialize? Itching to buy a million shares of Acme Generco, but just not sure how to pick an entry point? There’s gotta be a better way!
Well maybe there is, all thanks to those clever folks over at the options market.
None of what you are about to read is intended as financial advice nor trading recommendations. Read the full disclaimer (https://resourcetalks.com/disclosure/) before continuing.
Short Puts: Making Use of the Downside
The short put position is somewhat common among value investors who subscribe to the Buffet/Graham philosophies of very long term owning of high quality businesses. Being unphased by price declines in companies we are confident in owning at or below a certain price is a powerful position from which to sell puts. If we“know” that some asset is worth $100, we might be happy to collect a fee for agreeing to buy it in the event it falls to say $50, an attractive price for the value regardless; this can be seen as an easy win-win scenario for the put seller from a value investing standpoint, just so long as the capital is not better used elsewhere.
If there is a stock that you’d definitely like to buy at a lower price, and it has listed options, it is possible to effectively get paid for your willingness to commit to buy shares. You see, there’s other people out there in the market who might already own the stock, and want to insure it against losses. Or perhaps they simply want to speculate that the price will decline beyond some level. Or they’re an option dealer who collects spreads and hedges with shares. Whatever the case, their willingness to buy put options can be a phenomenal opportunity for those looking to buy shares. Note that similar to when we pay for auto insurance and rarely ever collect a claim, if we sell a put, we very likely may even get paid for not buying the shares.
To start with, there’s a few cautionary notes to take into account when selling put options. The dominant failures traders run into with selling put options are simply not anticipating how they’ll really feel if the option is exercised and shares are assigned. So it’s really crucial to be honest with yourself in answering questions such as before selling puts:
- Is there a chance that I will need the full amount of money required to buy the shares for something else?
- Am I willing to risk taking the full loss of share value if some event causes the shares to become worthless (bankrupcy/delisting/Etc.)?
- If the option is exercised, will I regret not having that money available to take advantage of other opportunities?
- If I’m very bullish on a stock, is it perhaps better to just be long calls or shares with the same money?
- If I’m possibly somewhat bearish the stock price, perhaps I should be flat or even buy the puts for now and sell puts later?
In most circumstances, if something fundamentally changed about the stock, or if you changed your mind about wanting to own those shares, you can usually either buy the option back or sell the shares if you’ve already been assigned, but you will have needed the capital available, as least as much as your broker requires for margin maintenance. It’s worth being somewhat conservative when selling any options, even puts which have limited downside (unlike call options).
Here I’ll show you how this might work for you, or at least you’ll have it as an investing tool to consider. Let’s dive right in with an example; for illustration, I’ll use Nexgen Energy:
As a base scenario, consider allocating a long position of up to $10,000 in Nexgen. True to the spirit of value investing, say we want to buy more shares as they get cheaper. For each whole dollar below $5 per share, we’ll allocate $2500 dollars. Since the recent price is below $4, we can start with buying 625 shares ($2,500/$4) immediately. The other $7500 is just set aside, waiting patiently for those more attractive prices, if they are seen.
Note that in order to reach the full target allocation, a very significant share price decline of 75% from current prices must be experienced. It’s simply very unlikely to get to put on the 3rd and 4th tranches; there’s a much better probability that half the money just sits idle.
Now let’s get a little more creative at puting the money to work with options. Here’s a recent shot of the ≤$4 strike NXE put options as of Jan 25th 2022 (AMC).
There’s no bids for the $1 puts, so we can’t sell those even if we wanted to (hint: we don’t). Likewise, there’s hardly any bid for the $2 strikes either. Given how wide spreads are, let’s focus on the December expiration cycle. For the stuff that is bid, note the implied volatility is a very healthy 80-90% (I didn’t select Nexgen purely randomly haha).
The most straightforward way to do this is we could just sell a bunch of $4 December puts and call it done. A perfectly valid trade, sure. Essentially, what that would look like is having a net share price of $4 minus the ≈$1.2 of premium equals $2.8 net risk per share. That’s $2.8 only if the option was exercised. But of course, the premium is kept regardless of if shares are assigned or not, so the $1.2 per share collected represents a very respectable 30% yield on the $4 share price, or can legitimately be rationalized as an even juicier 43% in the context of the $2.8 of risk. However, unlike owning shares outright, a short put position has no exposure to right tail outcomes. In other words, if during the next year, Nexgen shares rose 100% or 1,000%, the capital allocated to short puts would just max out at a 30% gain (or 43% of maximum VAR). After all, if we’re bullish on a stock, it’s the right tail we probably want. That right tail exposure might still be bought by other means, but just not with the same capital that’s tied up shorting those puts.
Now let’s get a little fancier with our option selling and try to build an analogue to the base scenario. Here, instead of acting incrementally in response to falling share price, we can sell a series of put options all at once and let the put buyers take care of the rest. We’ll sell 10 of the $4 puts at $120 each, 15 of the $3 at $75 each, and 25 of the $2 strikes at $20 each.
Assuming the order is filled, we’d receive a total premium of $2825 which we get to keep no matter what. If every single option was exercised, we would need to spend $13,500 on buying shares from whomever bought the options from us. The total net cost to us in that case would be $13,500 minus the $2825 premium equals $10,675. If the options are never exercised, the premium would yield ≈26% of the $10k maximum risked. Our returns in terms of where the share price ends at expiry are:
- If under $4, then we buy 1,000 shares for a cost of $1,175 net of premium collected. (Imagine being able to buy NXE shares for $1.175 right now while shares cost ≈$3.96. Obviously it’s not without warehousing risk, but keep in mind this is actually a fairly likely outcome of this strategy. It’s a pretty good deal for those who aren’t capital constrained.)
- Below $3 and we’d buy an additional 1,500 shares and our net cost per share would be $2.27, still 32% less than the $3 shares were assigned at.
- Below $2, full assignment of the total 5,000 shares, but our drawdown is still only ≈6%. That’s pretty remarkable to be buying shares all the way down, another 50% drop from current price and reaching full target share size while only having a drawdown of 6%! Compare that to the base scenario of being down ≈28% at the same level.
- At $1 there’s no more short options that kick in, so the cost basis stays the same and the drawdown of 53% is quite similar to the base scenario. Furthermore, both the upside and downside exposures are nearly identical (slightly fewer shares at slightly higher net cost).
Timing the Trade
Deciding when to enter the short put position is largely a matter of trader discretion. Similar to buying stock, selling a put is ideally done when shares are expected to bottom out. However, as described above, selling a long dated put is much more attractive when the implied volatility is high. While volatility tends to peak when price bottoms, this is not always the case. Volatility in options is actually more closely tied to supply and demand for the options and different options for the same stock can even have very different supply/demand.
If shares are falling when the put is sold, and the price and volatility mean-revert, the option will likely lose value due to time decay, falling volatility, and rising price all at the same time, which could either give the possibility of a very quick payout for a significant portion of the premium collected, or greatly increase the hurdle for the option to end up below the strike less the premium.
While not applicable to Nexgen, whenever options are being traded, there is potential risk posed by dividends the company declares. Special dividends further complicate things.
Tax implication should obviously also be considered as they pose significant drag on overall returns, especially given the short term nature of option trades.
This article should not be considered investment advice of any sort. No trading recommendations are being made in this article. Be diligent and do your own research before risking your capital. The investment decisions of the author are based on their own investor profile. This includes, but is not limited to, their risk profile, their cash balance and their debts. The author likely has a higher risk appetite than yourself. That’s why you may never assume anything on this website to be personally tailored to your situation. Resource Talks, nor the Author of this article are a registered advisory service and we do not give investment advice. Our comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time.
Am I wrong? Did I miss something? Great! We’re all here to learn. If you caught a mistake in this article, please start a conversation down below by correcting me and providing further literature for me and future readers to benefit from. Thanks!