Selling More Puts

In my last post, I mentioned selling puts to generate income. This strategy seems to me to be increasingly more attractive. There has been tremendous volatility in the market, which has been reflected in the price of options. The potential returns on cash are quite high, perhaps over 25% on an annual basis, and there is also some protection against buying too securities before dips. I'm thinking of transferring additional cash into the portfolio to take advantage of this, particularly as cash yields on savings accounts are declining more and more.

Here are some things to consider:

Do this for only stocks that I am willing to own. The worst case is that the price declines so much that I am forced to purchase shares at a loss, even after accounting for the premium. I had better be willing to own the stock at that price.

Determine a price that I am absolutely willing to pay. Even options with strike prices over 20% below the current trading price are paying high premiums, so it makes sense to look at prices that I think would be a steal.

Look at only actively traded stocks. Otherwise, the bid-ask spreads will be too great and the price for closing a position will also be high.

Look for contracts 3 to 6 months to expiration. This balances a higher time premium and ensures that cash will not be tied up for too long.

The market dipped significantly today before making a breathtaking rally at the close. I took a sampling of today's closing put prices, and despite the rally, the premiums available are still very juicy (all prices are at the bid):

GE Mar 09 Expiration:
$10 Strike: $1.00
$12.50 Strike: $1.55
$15 Strike: $2.35

American Express Apr 09 Expiration:
$10 Strike: $1.20
$12.50 Strike: $1.80
$15 Strike: $2.65

Freeport McMoRan Feb 09 Expiration:
$17.50 Strike: $2.23
$20 Strike: $3.10
$22.50 Strike: $4.15

Nokia Apr 09 Expiration:
$10 Strike: $.95
$11 Strike: $1.25
$12 Strike: $1.60

I wrote another 2 $10 Strike March puts on GE this morning.

GE at $10 seemed like a good trade to me. The stock would have to drop almost 40% from today's levels in order to trigger it. The likelihood seems low of that occurring. Selling it yields $1 per contract payable immediately. If GE drops to $10, the option is exercised, and I would have to buy 100 shares of GE at $10. But I've already collected a $1 per share premium, so I am still earning money. Moreover, GE pays $1.24/share in dividends, so the implied yield at $10 would be over 12%. Overall, it seems like a relatively easy way to make 10% ($1 premium on $10 strike) on cash in 4 months. The worst case is that GE falls below $9, but in that case, I would own GE at $9, which I am pretty sure I would be willing to do.

What's the worst that can happen?

This depends on whether the alternative is to sit on cash, or if the alternative is to buy the stock. If the alternative is to sit on the cash, then the worst case scenario would be if GE shares collapse, and trade at $5 on March 20. Then I would be forced to buy the stock at $10, and the $1 premium I collected wouldn't be enough to cover the losses. This is mitigated by the fact that GE pays $1.24 dividends which they recently affirmed for 2009. Management guarantees have been pretty useless lately, but assuming they are correct, the $1.24 translates to a 24.8% annual yield. The mitigating factor is that the dividend yield will be very high, and I would own the stock at a ridiculously low price.

If the alternative is to buy the stock, then the worst case scenario is if the market rebounds dramatically and GE doubles to $34. GE was trading above $34 as recently as April, so this scenario isn't that far-fetched. In that case, I would miss out on the return. I would still collect the premium from the option, which will expire worthless, but I would have missed out on a 100% gain had I simply bought the stock. I can always close my put position as well, as an increasing stock price will reduce the price of the put. I could then take my cash and use it to purchase shares. Of course, if I bought the stock at $17 and it drops to $5, that would be a far worse result.


When I made this trade this morning, GE had fallen quite a bit and the option was trading at $1.45. I sold two puts and collected about $280 in premium after commission. Assuming that GE doesn't fall below $10 in March, that's a 14% return in a little over 4 months. I selected an extremely low strike price and I'm assuming there will likely be no exercise. I could have selected a higher strike price and collected an even higher premium. Overall, this seems like a good way to take advantage of all of the current volatility in the market.

Anyways, I will be out in Costa Rica for the next week, so will be taking some time away from the market. Hopefully, nothing too crazy happens in the meantime.