I’m sure I’m not the only one to notice that many of the constituents of the FTSE 100, are trading at prices a tad on the low side. Or should I say, they were.
Since the start of the year there has been a steady rise in the index and it’s now poking its nose back above 7,200. That’s quite an increase since the lows we saw around Christmas.
Maybe you’d like to jump aboard the good ship FTSE before the Brexit fog eventually lifts, but are a little nervous that shares could drop again in the short term.
So, what if you could set a lower price you were happy to pay for a stock and get paid whilst you waited to see if it triggered? Sound good?
Well you can. The technique is called selling cash-secured puts and it’s the perfect complement to selling covered calls.
Selling cash-secured puts
Okay, let’s get the jargon out of the way.
A put is an options contract that allows the holder to sell a set number of shares, at a fixed price, within a certain period of time.
Now, if you are thinking that the definition sounds familiar, it’s because it’s virtually the same as for a call. I’ve simply swapped the word buy for sell.
A cash-secured put simply means that the seller has the requisite amount of money ring-fenced in their broker account to pay for the shares if required.
And selling a cash-secured put means that we are going to sell puts on shares that we would like to own. That will bring in premium but we must ensure that we have the cash available to buy the shares if needs be.
So, let’s say that we have done our research and decided that a particular share would be an excellent addition to our income portfolio. The stock pays a good dividend and we may also decide to sell covered calls against it.
The Brexit turmoil means that it’s trading at a price that we are happy to pay, so we could just march straight on in and buy a thousand shares. Perfect. Job done.
There is absolutely nothing wrong with doing that. You could then sit back and watch the dividends and covered call premium roll in.
Or, for no extra work, we could simply sell a put instead.
We would be paid a premium for selling the put and could select a price lower than the current share price and the length of time we would like to honour the commitment for.
That’s the strike price and expiration date respectively.
Then, if the put is exercised, we will be paying less for the shares than if we simply bought them outright. Pretty cool, eh?
Let’s have a look at an example.
Big Oil Plc
Big Oil — with its 6% dividend yield — is the sort of share that would look at home in any income-seekers portfolio. It’s currently changing hands for 543p per share and I’d be happy to pay that.
Or, even better, what if I could pick the shares up for 530p each — that would be even cheaper.
And if I could get paid 11.5p per share whilst I waited — that would be fantastic.
Welcome to the world of cash-secured puts.
Getting paid to wait
My online platform is currently showing that I can sell a Big Oil 530p strike April put for 11.5p per share.
As with the calls, a single put represents 1,000 shares.
So, I am committing to paying £5,300 for a thousand Big Oil shares if the put option is exercised between now and April 18th. That’s 62 days away.
The buyer of the put will pay me £115 for my commitment. That is mine to keep whatever the outcome of the trade and represents an annualised yield of 12.8%. Not too shabby.
When you sell the put you are entering into a commitment that has two possible outcomes.
If the share price stays above 530p, the put expires worthless. You keep the £115 premium and you are free to sell another put with a strike price and expiration of your choosing.
That’s a pretty good source of income.
But, what happens if the put is exercised?
If the share price drops below 530p, the owner of the put is likely to exercise it. That means that you will be obligated to buy 1,000 Big Oil shares for 530p each.
Is that a problem? Well it shouldn’t be. Remember that we analysed Big Oil and decided that we would be happy to own the shares for the long-term.
We were also happy to pay up to 543p each for them.
So, if you now only have to pay 530p for them and you have collected a premium payment of 11.5p to boot, that’s a pretty good deal.
However, the eagle eyed amongst you may have spotted the ‘risk’ with this strategy.
The buyer of the put, has bought it for a reason. If the price of their shares drops below a certain level they want to ensure that they can sell them at a fixed price.
As the seller of this ‘insurance’, you have committed to pay 530p per share regardless of the price they are trading for when the put is exercised.
That sounds scary!
Well, in theory it could be, but it’s actually less scary than simply buying the shares outright.
Let’s imagine you buy the shares at their current price of 543p and that they then drop to 500p over the next few months. You would be out of pocket by 43p per share. Not nice.
Now, let’s imagine that instead, you had sold the 530p strike put we have just described. After the drop to 500p, the owner of the put would certainly exercise it and you would have to buy the shares at 530p.
That’s a 30p difference. However, you have also been paid 11.5p for the put and can offset your paper loss with that.
That means that you are out of pocket by only 18.5p per share. That’s a whole lot better than the 43p loss if you had simply bought the shares outright.
And of course, you may repeat this process quite a few times before one of your puts is exercised. All that premium adds up to provide a very nice downside buffer if it’s ever required.
So, as long as you actually want to own the shares, this is a great way to initiate a position and get paid whilst you wait.