4 Basic Rules For Selling Puts

My 4 Basic Rules For Selling Puts (Naked Or Cash Secured)

One of my favorite investments is selling puts. Whether they be naked puts or cash secured puts, it doesn't matter as to me they are the same thing. Basically I am selling someone the right to assign (or put) shares to me from a company at a price that I have agreed to. Take for example one of my preferred stocks, Microsoft.

If I sell a put to another investor at the Microsoft stock strike of $25.00, that investor has the right to assign shares to me at any time up until the expiry of the option, at $25.00. If Microsoft was to trade at or below $25.00 by the time the option expired and I did not buy back the put or roll it, then I can be pretty well assured that the investor will assign or put the shares to me at $25.00. You have to remember though that once I sell a put, I can be assigned AT ANY TIME right up until the put option expires. Naturally if the stock stays above $25.00, there would be no reason for the shares to be assigned. However if the stock falls below $25.00 and falls far enough, being assigned early is quite common.

This article on my 4 basic rules for selling puts assumes that readers are aware of selling puts as a strategy and how they function. If you are not, I would suggest this article understanding selling puts and reading this article on a simple put sell. It gives a very good understanding of selling puts. If you have further questions you can check out the related articles listed at the end of this article and you can always contact me if you still have a question or two. Just remember that I cannot give out specific trade advice.

Selling a put can be a fabulous strategy if done properly. While it is a reasonably common strategy many investors are afraid that the "risk" is too high. In fact many brokers and those investors unfamiliar with options, constantly spread this falsehood simply through sheer ignorance of how selling puts or selling options in general, works as an investing strategy.

For those investors with a working knowledge of options, selling puts is without doubt a very viable and profitable investment strategy and yes, it is an investment strategy and not gambling. I suppose a case could be made that options are gambling in that by selling a put or call, the investor is "betting" that the stock will not reach their strike and thus the sold option will expire worthless and the investor will keep his premium. But for many who invest through selling puts, we do so for investment purposes for a variety of reasons and often are not only hoping, but actually want the stock to reach the option strike we have sold so we can either pick up shares at a lower price than was currently available, or sell our sales at the covered call strike sold or buy back the option and roll it further out for often a great deal more premium. It is always easy to be negative about strategies we do not know. Instead I find it very advantageous to learn all I can and try to apply different strategies through paper trading to see if I can profit from a strategy I had never considered before. Being open minded and willing to learn has a lot to do with successful investing.

Rather than delve deeper in this article into the "reasons" an investor would consider selling options as an investment strategy, you can read these related articles:
Why Sell Puts
Selling Puts For Profit
Why I Believe Selling Puts Is Superior To Covered Calls

Needless to say, selling puts can be profitable and highly rewarding if some basic rules are applied. On the other hand selling puts without a strategy or plan can be a recipe for disaster. Here are my 4 Basic Rules For Selling Puts.

Rule #1 - Only Sell Puts On Companies I Would Own

I never sell puts on stocks of companies that I do not want to own. Why would I? No matter how great the premiums being offered, if a company is not one I would like to own there is no point in selling puts on its stock. I want companies that will "withstand the test of time". The choice NOT to sell puts against companies I would not want to own is an obvious one, when you consider stocks in general. Let's look at a few examples to see why Rule #1 is important.

Below is the 5 year chart on Coca Cola (KO). I have marked the low for the past 5 years which was on March 2 2009 at $37.44. Selling puts on Coca Cola makes a lot of sense. I know from just looking at the chart that this stock has recovered from collapses before. Without even looking at the earnings I can see that this stock has a nice pattern of recoveries. This means I can safely sell puts and if I am assigned shares I can sell covered calls to get out of the stock. If the stock should fall away from where I sold my puts, I have confidence to sell more puts to average lower into the stock and eventually work my way out of the stock through a combination of selling covered calls, selling puts and eventually the stock should recover and my shares will eventually be exercised away from me. All of this has to be done with a profit. To realize such profit a stock I have sold puts against cannot collapse and never recover. There are a lot of stocks that in fact do collapse and not recover. Think AIG.

I would definitely sell Coca Cola puts until this pattern of recoveries no longer applies. Coca Cola should withstand "the test of time". In other words it should be still grinding higher in value and increasing its dividend decades from now.

Below is the 5 year chart for Bank Of America (BAC). I have marked the low which was March 2 2009 at $3.00. Just looking at the stock chart without even worrying about the earnings, gives a clear indication that this stock would be difficult to recover from. There has been no recovery to date. There is a great article called A Tale Of Two Investors that looks at two investors who were trapped when Bank Of America collapsed. It shows what investors with option knowledge can accomplish through applying their strategies.

With the stock at all time lows many investors would consider selling puts for obvious reasons - the stock is cheap. But just as investors found with Research In Motion stock, which analysts claimed was cheap all the way from $150.00 down to $45.00, a stock like Bank Of America is cheap for a reason. This is not a stock that meets my Rule #1. I do not want to own Bank Of America, so why would I sell puts when there are thousands of stocks to choose from.

Below is Crocs Inc 5 Year Stock Chart (CROCS). I am sure everyone knows the story of Crocs. It was at one time a hot stock. On March 16 2009 it set an all time new low of $1.00. The problem with selling puts against a hot stock is that, there is little trend to follow. When the panic to get out is on, who knows what strike to sell and will the stock recover? Crocs does not meet my rule number 1. I have to ask myself if I had sold puts in Crocs in 2007 at $60.00 would I have confidence that the company's stock would recover? How would I feel holding puts at $60.00 when the stock fell to $40.00 almost overnight? When I sell a put that earns me perhaps $1.50 and the stock collapses and that $1.50 put may cost me $10.00 or more to buy back to close, it's a pretty sick feeling. At $10.00 to close a $1.50 put, it is a 566% loss which is huge. This is the type of stock I cannot sleep nights with.

Selling puts is a long term strategy that earns small profits that compound over time into big profits. Selling puts on Crocs could wipe out years of earnings. I suppose a case could be made to sell puts when the stock hit $1.00, but at that price an investor who believes the stock will recover, should spend $500.00 and just buy shares. $500.00 in Crocs, would today be worth $13,500.00 or 2600% return. These trades always look good in hindsight, but you have to ask yourself would you have bought in at $1.00 and held until today - July 8 2011? For example, I bought into Citicorp at 1.00 when it crashed, but I sold out within a few months as it does not meet my investing strategies and philosophy. I never considered doing this with Crocs.

Below is Yellow Media Inc, (YLO) 5 year stock chart. This company trades on the Toronto Stock Exchange or TSX. I show this because this stock was a darling of the analysts. With a monthly cash payout of at one time more than 10%, analysts praised this stock and as it fell still praised it. When it reached $5.00 analysts loved it even more. The news continues to get worse and the company's once highly touted dividend has already been cut and is considered no longer viable.

MY YELLOW MEDIA TRADES AND HOW I GOT OUT: At one time I considered Yellow Media a great stock. Options were thinly traded but I could earn decent premiums by going out 6 months at a time. Combining 6 month options with the dividend, I was earning 15% annually. In 2006 I had been exercised out of my stock and I sold January 2007 $12.00 puts to get back into the stock. In January 2007 the option expired. I then sold 6 months out at $12.00 which expired but the next 6 months (January 2008) out were assigned. I then sold a 6 month covered call at $12.00.

Then in January 2008 the below chart is what the early warning tools showed me about Yellow Media Stock. This chart is from my trade records. The notes on it are from March 1 2008 when I sold my shares and left the stock behind. I have also left up the MACD settings in case you wish to try them out.

The early warning tools showed me that the lower Bollinger Band was repeatedly being violated, normally a sign that the stock is going to fall further. If you look at the previous break in 2006 you can see that the break was short lived and the stock quickly recovered back above the lower bollinger band. Meanwhile though MACD had been negative since April 2006 which was almost 2 years, it had now turned decidedly down. The number of investors selling was growing. I sold my shares and held onto the calls which were now naked calls - in other words no stock being held to cover the calls.

Luckily I sold at a good time. You can see from the above Yellow Media Chart that the stock has never recovered. This is why it is so important to only sell shares in companies you would own. When I was assigned shares in January 2008 I thought it a reasonable investment based on the cash payouts which are shown as dividends on the chart. However the only thing that ever concerned me about Yellow Media was that this company is in one area of business only, a bit like Crocs is. I much prefer a company with a more diversified base of products. Even Intel and Microsoft although tech companies, have a wide range of products to generate profits. This is why picking the right stocks to sell puts against is so important, and then watching those stocks using such an arsenal as the early warning tools, which has often saved me from disaster.

Below is General Electric 5 Year Stock Chart. I have included this stock to discuss selling puts against companies such as General Electric. GE is a very diversified company which was hurt through the 2008 bear market because of its financial wing of operations. But General Electric is more than a financial company. Therefore when it collapsed many put sellers would have considered it a viable put selling investment. Indeed since 2009 it has had a nice trend for selling puts against. This is why it is so important for put sellers to stay with companies they believe have a viable business model and General Electric certainly falls within that category. Therefore if a put seller had been selling puts in 2006, 2007 and 2008 and been caught in the downturn, they may very well consider the sell off, as an opportunity to own shares in a large multinational at extremely low prices. It is all up to the individual investor as to what they consider a put opportunity.

Below is Avon Products 5 year stock chart, which has not recovered to the highs of 2007 and 2008. Could this be considered a viable put selling opportunity? If an investor was keen to eventually own the shares, Avon Products does exhibit a decent trend even though it has failed to recover to its 2007 and 2008 highs. It all comes back to the individual investor's level of comfort. Just as in the case of General Electric above, if the investor feels that these companies are great stocks to own if assigned and believe that through selling covered calls they can work their way back out of the stock to start over, companies like Avon Products which show a general trend that can be traded through selling puts, definitely could be considered for put selling strategies.

The last chart I want to discuss is Wal-Mart Stores. Below is its 5 year chart. Almost like the Avon Products stock, Wal-mart stock has not recovered to its 2008 highs, however note how during the 2008 to 2009 bear market collapse, Wal-mart did not fall to new lows. It fell, make no doubt about it, but it did not make new lows for the 5 year period. This gives a lot of confidence when selling puts in a stock. For this very reason, Wal-mart is a stock I would consider selling puts against to eventually own shares. The trend is comfortable and the company is so large that should it take a dip it could be considered an opportunity rather than a reason for concern.

Summary Rule #1

You can tell from the above charts that Rule #1 can be applied to a variety of stocks. The stock does not necessarily have to be in a confirmed uptrend, although that certainly helps. But what I am looking for, is stocks that if I was assigned, I would sleep well knowing that they are well managed, diversified, large caps, that pay me a dividend, allow me to sell covered calls against my assigned shares and sell more puts and in a downturn, I can look at the lower prices as opportunities to add more shares for the inevitable recovery.

Article Index
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