In Options Trading part one of this two-part series on options trading we discussed the strategy of writing covered calls. This time I’m going to introduce another relatively safe options trading strategy that fits so well with Value Investing techniques that Warren Buffett uses it.

And that strategy is selling puts.

Options Trading Based on Fundamentally Solid Stocks

Normally options traders sell puts when they feel the stock will rise. If it does, the put expires worthless and the trader pockets the premium. That’s not a bad strategy in and of itself, however when combined with a sound Value Investing strategy, the synergy can help wring out extra profits while adding a dose of discipline to the mix.

Before I outline the combined strategy, let’s take a step back and analyze the risk profile of some options trading strategies. Regardless of the investing strategy you use, it is vitally important to look not only at returns, but also at risk. The majority of investors don’t do this. If you don’t believe me, ask someone you know, who invests in the stock market, what their returns were last year. They’ll most likely be able to tell you, especially if they made money.

Next ask them what their risk was like. Nine times out of ten you’ll receive a blank stare.

Unfortunately this lack of knowledge ends up costing oblivious investors lots of money over their investing lifetimes. Since we don’t want to end up in that category, we need to focus on the risk part of the investing equation as well as the returns part.

Options Trading Strategies Risk Profiles

So, what are the risk profiles of the various options strategies?

Since I only recommend two options strategies, those are the two I’ll look at. Be aware there are many other strategies out there and you should look at the associated risks before using any of them.

For example, if you decided to sell uncovered calls, that strategy would be extremely risky because the underlying stock could, theoretically, rise indefinitely and therefore expose you to unlimited risk. That’s the sort of analyses you need to do before investing your money.

However, let’s move on to the two strategies I recommend for Value Investors. As we discussed in part one, writing covered calls can be very profitable. Of course there is the risk of potential lost future profits if the stock price rises above the striking price and keeps going up. However if you follow the rules I outlined in part one, your investment will always be profitable, so you forgo potentially greater profits for limited, but fairly certain profits.

Selling puts, on the other hand, is completely different. As a put seller you’re banking on the underlying stock’s price rising. As the stock’s price goes up, the put’s value goes down — and since you’re a seller, you make money when the put’s value declines.

If the stock’s price falls, the put’s value will increase and you, as a put seller, could face a loss. However, unlike an uncovered call, the loss is not unlimited. A stock’s price can only fall, theoretically, to zero, however it’s a rare stock that goes to zero. Usually stocks, especially well-selected stocks, decline to some value that’s greater than zero.

The other factor to consider is that short puts are always uncovered, but the risk is always limited because the underlying stock’s price can only fall so far.

Theoretically the price should fall no lower than the underlying stock’s intrinsic value, however since we are dealing with relatively short time periods, intrinsic value is probably not a good indicator to rely upon.

Intrinsic value works reasonably well in the long term, but the markets have proven that short-term pricing is based on emotions far more often than logic and therefore prices can, and do, fall below intrinsic value over short periods of time.

Keep these things in mind if you decide to sell puts.

Always use Fundamentally Strong Stocks
in any Options Trading Strategy

As with the covered call strategy, the key is to select fundamentally strong stocks. Whether you’re writing covered calls or selling puts, you must start with a fundamentally solid underlying stock. Doing otherwise will only increase your risk and turn you into a speculator rather than an investor.

Now that we’ve covered risk, let’s move on to the actual strategy. As a value investor you look for strong stocks that are undervalued. However it’s not always possible to find lots of strong, undervalued stocks. In strong bull markets it might not be possible to find any undervalued stocks.

However since we know that markets are irrational in the short term, we can use that to our advantage. First you must decide which stocks you like. Again, and I can’t stress this point enough, only look for stocks that have very strong fundamentals and strong economic moats.

Once you have a list of stocks, the next step is to decide what you’re willing to pay for the stock. Usually you would calculate a stock’s intrinsic value and then build in a reasonable margin of safety. Once you’ve calculated that price, you’re ready to implement the options trading strategy.

To do so, simply sell puts with striking prices at the price you just calculated. The lower the price, the lower your risk. For example, if you sell puts with striking prices of 10, your maximum loss is $1000 per contract (recall that one options contract controls 100 shares). On the other hand if you sell puts with striking prices of 20, your maximum loss is $2,000.

Of course, as I mentioned earlier, stock prices rarely go to zero, so your potential loss is more likely to be the gap between the striking price and the underlying stock’s book value.

By selling puts with striking prices at your calculated intrinsic value less the margin of safety, you’re essentially saying that you would have no issue with purchasing the underlying stock at that price. And if exercise occurs, that’s exactly what will happen.

In essence, you’ve now removed the decision of when to purchase the underlying stock from your control (at least until the put expires). If exercise occurs, you’ll buy the stock. If not, you won’t. And anytime you can remove emotions from your investing decisions, that’s a huge plus.

The Payoff from Trading Options

Now once you sell a put, you’ll collect the premium. This is cash in your pocket you would not otherwise have. If the put expires, the premium is pure profit. If exercise occurs, the premium will essentially discount your basis in the stock, so your cost basis will actually be a bit less than the striking price.

And since you feel the long-term prospects of the stock warrant purchasing at the price you calculated, if exercise occurs, you’ll be getting into the stock at a favourable price. Of course you may have to hold the stock for some time in order to realize a profit, so you can see why I’m so adamant the underlying stock have strong fundamentals and a wide economic moat.

The downside to this strategy is that if exercise occurs, you’ll end up paying a higher price for the stock than you would on the open market at that particular time. However the higher price you end up paying still includes a reasonable margin of safety and gets you into an undervalued stock that should perform well over the long term.

In fact, this is exactly what Warren Buffett does when he likes a stock that is currently trading at a price he’s not willing to pay. He simply sells puts at a striking price he’s happy to pay and waits. If the stock gets put to him, he happily buys it, knowing he’s just purchased an undervalued stock at a great price with a built-in margin of safety.

As I mentioned at the beginning of part one, there are many different options strategies available. However I feel the two we’ve just discussed are the safest and most profitable to use with a sound value investing strategy.

If you’d like to include options in your investing toolbox, writing covered calls and selling puts are the best way to get started. Just remember to ensure the underlying stock has exceptionally strong fundamentals and a wide economic moat.

 

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