Why You Should Sell Puts

You're Almost Always Better Off Selling Puts Rather Than Buying Stock - Here's Why

On Friday, December 16, 2016, BMY closed @ $58.62/share and my single December $55 short put easily expired worthless.

The final booked option income returns were $183.50/share over 121 days for a decent 10.06% annualized ROI.

The trade had a little more drama than the benign, uneventful final results would seem to imply.

First, I screwed up the entry big time.

Instead of the December $55 strike, I originally thought the $1.89/contract I received for selling a single BMY put was for the October 21 2016 expiry, and for that duration, I was locking in a pretty sweet 18%+ annualized return.

Not quite, as the real rate was nearly cut in half once I made the correct calculations.

Second, the stock sold off significantly over the course of the trade before rebounding back very close to my original entry point.

During most of September, BMY held steady around the $55 share price level, but then sold off and then spent most of October around - and even below at times - the $50 level.

But at the December 16 2016 expiration, BMY closed @ $58.62/share, or $0.20/share above my original entry point 121 days earlier back on August 17, 2016.

So even though I screwed up the set up, and even though I was wrong about the downside, the trade still produced decent to good returns over 4 months with no intervention or repairs required on my side.

That's What I Call a Structural Advantage

Over those 121 days, the stock was up $0.20/share while my returns worked out to be equivalent to $1.83/share, or 9 times better than a stock only investor who entered the position the same time I did would have done.

Even factoring in dividends still doesn't make it close.

At one level, this trade underscores a very important truth about selling puts:

The ONLY time you're not better off selling puts rather than buying the underlying shares is if the stock in question makes a big move higher.

But even there, you don't lose money. You still make good returns, just not as much money as you could have made had you been able to somehow correctly guess the precise future.

In every other instance, selling puts makes it easier to make money (often at good to great rates) and gives you one thing that stock only investing can never provide - downside protection.

(Inside the Leveraged Investing Club, we view and treat our short put trades as campaigns rather than one-time events and crank this process into overdrive.)

It's good to consciously remember this core structural advantage from time to time.

But I'd also like to take the time today to dive deeper and consider another structural advantage that's less obvious.

When we sell puts, we're selling insurance. We know that quite well.

But what are we actually insuring?

Literally, we're insuring a stock at a certain share price (i.e. the strike price at which we write or sell our puts).

If the Sleep at Night Strategy were a binary, one-time event, that might be a good enough answer.

But our strategy - more specifically our trade management process, attitude, and capabilities - is a very dynamic process.

To be blunt, we can renegotiate the hell out of an insurance policy.

So it's simply not realistic to say we're insuring the underlying stock at a certain share price.

And what about that share price? I've referred to the regular day-to-day volatility of fluctuating stocks more poetically (or less so depending on your perspective) as zigging and zagging.

BMY over these 121 days is a perfect example. It started above $58, zigged and zagged lower to below $50 and then zigged and zagged higher again, pretty much making a full circle over a four month time period.

If I insured the stock at the $55 price level and then it traded down into the upper $40s, but I still walk away at the end of the day with no adjustments required and a 10.06% annualized return, it's hard to make the case that I truly insured the stock at $55.

That's like betting that a butterfly will fly a straight path and then getting paid anyway when it lands on a flower.

While there is a definite logic to the pricing of a stock over the long term, there's also a great deal of randomness and noise in the near term.

But like the butterfly - turning here, dipping there, shooting up higher and off to one side again - the stock generally gets to a rational place over time.

So between all the short term zigging and zagging of the stock and our great flexibility with the dynamic terms of our trades, I would make the case that what we're really insuring against is the possibility that underlying business completely falls apart.

The butterfly generally gets safely to where it's going, although we may not always see in advance which flower he's navigating toward.

When we sell puts the Sleep at Night Way, we're basically scouring the horizon for hungry birds and, in the absence of those predators, betting that the butterfly successfully lands on a flower - and any flower will do just fine.

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Warren Buffett Zero Cost Basis Portfolio Current Equity Holdings:

KO - 125 shares
KMI - 100 shares
BP - 100 shares
MCD - 30 shares
JNJ - 25 shares
GIS - 25 shares
PAYX - 25 shares

Open Market Purchase Price: $20,071.83

Less Booked Option Income: $16,341.71

Tot. Discount: 81.42%
Adj. Div. Yield: 19.59%