Wednesday, June 27, 2012

Put Options Explained

A lot of people hear the word options with respect to stocks and think it's a high risk venture. While options are for everyone I feel they definitely have a place in a portfolio. I prefer selling put options to call options which I will explain why in a future post.

Put options, in a nutshell, are a contract between two parties where they agree to exchange the underlying stock at a specified price known as the strike price by a certain date. The buyer of the put has the right but not the obligation to sell the underlying by the expiration date at the strike price, where the seller of the put has the obligation to purchase the underlying if the option is exercised. The buyer has to pay the seller of the put option the premium for the right to sell the shares. Option contracts for stocks are based off 100 share lots. Therefore 1 contract is really referring to 100 shares.



Some examples of the calculations will be helpful.

Johnson & Johnson closed on Friday 3/23/12 at $64.55. The current dividend payout is $2.28 meaning a yield of 3.53%. We'll look at the $62.50 Put expiring 7/20/12. The option ended Friday with a bid price of $1.25 and an ask price of $1.29. So we'll use $1.27 for our assumed price that we can sell the put for. We'll ignore taxes for this exercise however they definitely need to be considered since the premiums are considered short term capital gains and will take a big chunk out of your return.

If the stock price is selling for less than the strike price before or on the expriation date the option could be exercised and the premium would decrease the cost basis of the shares. If the option is not exercised then the seller of the put option gets to keep the option premium. The creation price of a put option is the Strike Price - Option Premium = Creation Price.

Creation Price = $62.50 - $1.27 = $61.23

This is the price where the seller of the option would breakeven on the trade. If the stock price is less than $62.50 but more than than $61.23 and the option is exercised then a profit would still be made. This is your downside protection.

Downside protection is calculated as:

DP = (Current Price - Creation Price) / Current Price = ($64.55 - $61.23)/$64.55 = 5.14%.

The underlying has to decrease by more than 5.14% or $3.32 per share to lose money on the put.

In order to calculate how much money needs to be kept free in your account to cover the put option you take the Strike Price * # of contracts * 100 = $62.50 * 1 * 100 = $6250.

The premium received is calculated as Option Premium * # of contracts * 100 - Total Commission = $1.27 * 1 * 100 - $8.70 = $118.30.

The premium yield is calculated as:

Premium / Cash Required = $118.30 / $6,250 * 100 = 1.89%.

CAGR of this premium yield is calculated as:

CAGR = (Premium Yield + 1) ^ (1/(Days to Expiration/365.25))-1 = (0.0189 + 1) ^ (1/(116/365.25))-1 = 6.08%

Most brokerages will give a profit/loss chart based off different stock prices. I've made the following chart for this put option.



As you can see an increase in stock price caps your profit at the premium that you received while you don't have downside protection.

Most brokerages have a commission schedule for options where you pay a base commission and then a certain amount per contract. If you have the capital it is best to sell multiple contracts at once since your commission per contract goes down. For example:

Base Commission: $7.95
Commission per contract: $0.75

Commission for 1 contract = $7.95 + $0.75 = $8.70
Commission for 2 contracts = ($7.95 + 2 * $0.75) = $9.45
per contract = $9.45 / 2 = $4.73
Commission for 3 contracts = ($7.95 + 3 * $0.75) = $10.20
per contract = $10.20 / 3 = $3.40

By selling 2 contracts you reduce your per contract commission by almost half. This can significantly increase your returns in the long run.

Conclusion:

When running through the calcuations I like to target a premium yield that would equate to a 10% CAGR and a price that is around what I consider to be fair value for the stock.

The downside to selling puts is that you could have bought at an even lower entry price or decided not to buy the shares at all if a huge fundamental change occurs with the company to quickly erode it's stock price. If you stick to the behemoth companies your return is less but you also won't have to worry as much about large price swings that could bring about purchasing at a severely overvalued price.

The reason I prefer to sell put options is that they can reduce your cost basis should the option be exercised versus buying outright and give you additional income while you wait for your price. Through selling puts you can figure out your target entry price or entry yield based off your analysis of the company and sell puts to target that price. If you're selling puts on large mega-cap companies such as JNJ you won't get the best premium however you can still get better return than parking the money in a savings account if you are targeting that specific stock at a specific entry price.

1 comment:

  1. Nice job covering the basics of puts. I currently like to sell puts also against companies I'd like to own or want to add more shares in. As you point out, one of the drawbacks is that in a market correction you could have ended up buying the stock at a cheaper price. The other drawback is that if the stock has a nice run-up you could miss the opportunity to own the stock, although you still collect the premiums. I think a combination of purchasing shares and selling puts is a great way to dollar cost average.

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