Review Of Put-Selling Instead Of Stock-Buying
This is a 2013 synoptic review of a groundbreaking 2003 book, Put Options, by Jeffrey Cohen, featuring cash-secured Put-selling as a possible replacement for stock-buying. Although an uphill argument in 2003, the idea that Put-selling can be at least as conservative as traditional investing now seems mainstream if not hip. See the video at the TD Ameritrade affiliate TastyTrade.com: Liz & Jen Explain Puts.
For those unfamiliar with Options: in my opinion, books and courses are a miserable way to learn the basics of Options trading. Instead, dabble with Options in a free paper-trading account as available from numerous online brokers (after choosing one that has low Options fees)--meanwhile surfing for numerous free internet tutorials and videos, including those probably supplied by your broker.
Suggested books on Put-selling.
- Put Options by Jeffrey Cohen, 2003. Mr. Cohen's book is rather wordy, mentions obsolete software and neglects ETFs. Nonetheless, Mr. Cohen's Put-selling system remains among the most simple and yet well-rounded. My synopsis below may help cut to the chase.
- Put Option Writing Demystified, by Paul D. Kadavy, 2004, 2009. A somewhat pedantic little book but which helps to clarify the pros and cons of ETFs, rolling-forward, rolling-up, rolling-down and other strategy variations.
- How to Sell OTM Put Options, by Buchanan and Palmer, 2012. This book is similar to Mr. Cohen's in conservative attitude but rather different in approach. Includes a free CD with a "Buy-Back Worksheet" which might help with exit strategy.
Eventually, I suggest buying all the Put-selling books you can--after reading the negative reviews at Amazon. Even 4-star Options books often have one or two negative reviews with valid precautions.
Jeffrey Cohen's Put-sell parameters. (Chapter 8.)
- Do not over-emphasize Options parameters. Use the same stock-picking standards as for stock-buying, except also making sure of adequate Options volume. You can of course use any favorite stock-picking system. Mr. Cohen suggests picking stocks that have high fundamental values, are uptrending, are relatively far below their 52-week peaks, and at or below support levels.
- Sell 1-year Puts with a premium that is 10% of strike or slightly greater--thus setting a minimum target gain of 10% annually. Thus possibly achieving around 15% annually.
- If desired, via database searches for relative Put premiums, and via adjustment of strikes and expirations, you might seek out Put-sells with higher annualized expectations, but if so must expect higher risks.
- If as suggested by Mr. Cohen you are Put-selling individual stocks, diversify with at least 15 positions, ideally 30 positions.
- Consider closing a position if this would generate an annualized profit significantly higher than the 10% annual target.
- Buy-to-close when a stock falls below strike--then sell-to-open another Put with a further expiration, aka "rolling forward." Mr. Cohen suggests using the same strike price, but a lower strike might be considered. Thus losing on the old position but partially making up for this with a higher premium and a lower risk. It can also be feasible to allow the Option to be exercised, in which case you end up buying a stock which you can sell the next day.
- The total value of Put-sells is determined by multiplying strikes times Puts. For example, each 100-Put contract with a strike of $50 means that you agree to buy 100 shares of stock x $50 = $5,000. Mr. Cohen suggests that with his 75% hedging method, as explained below, total Put-sells may be 200% of account value. If so, then in a sudden stock market crash, your broker may automatically sell anything in your account in order to fill your Put contracts--which should be no problem with the 75% hedging. However if you do not use 75% hedging, you might want to keep Put-sells down to the same level as if you were buying stocks--such as 1/2 to 3/4 of account value.
Additional considerations. The following considerations are not thoroughly discussed by Mr. Cohen and important enough to mention to beginners.
- Increased taxes vs. increased leverage. On the one hand, Put-selling usually does not qualify for "long-term capital gains." On the other hand, Put-selling requires little up-front cash, thus enabling you to risk more in the stock market or to buy more US Treasuries, as desired.
- Shop for low trading fees. Before selecting a broker, read reviews and check out their Options trading fees.
- Using ETF Spreads for hedging. Conversely, if extreme stability is your goal, greater precision might be gained by using the same ETFs for both long and short positions. This results in Bull Put Spreads--perhaps with "legging-in" for improved advantage.
- Using ETFs for simplicity. In any case, popular ETFs with high Options volume, such as SPY and IWM, can eliminate stock-picking. ETFs also can reduce the minimum startup capital from around $50,000 to around $5,000.
- More aggressive expirations. Mr. Cohen recommends 1-year expirations, generally the safest. However you can start with 1-2 month expirations which are more profitable--then when stocks fall below strikes, roll-forward to longer expirations and lower strikes.
- Less aggressive leverage. Mr. Cohen suggests 200% leverage, which I would not suggest for the average investor, and which might be unnecessary if selling shorter-term Puts.
- Studying benchmarks. Mr. Cohen's 2003 book understandably spends many pages on arguments and backtesting in defense of Put-selling, which are somewhat tedius as well as one-sided. I suggest every 2013 reader just quickly skim those chapters--and study the more objective performance history of the CBOE PutWrite Index.
Also see the "Post-2008 Precaution" at the bottom of this article.
Jeffrey Cohen's Put-buy hedging. (Chapter 9.) The general idea of Mr. Cohen's hedging method seems to be to insure 75% of current value via low-priced out-of-the-money Put-buys on related indexes. Similar Put-buy-on-index routines are among the standard methods for professional investors to insure or delay the selling of any investment that has positive beta, i.e. is long on the stock market. Mr. Cohen emphasizes precise matching of indexes to equities, but admits that this method of hedging reduces long-term gains and can not achieve complete stability. Mr. Cohen argues that this is an affordable expense which should be considered as similar to automobile insurance premiums which you buy while hoping for a complete loss. However, Put-buying is not emphasized by most Put-selling books. For greater portfolio stability, consider Bull Put Spreads. Or on the other hand, you might ignore the complication and expense of Put-buys, while hedging via trend-following and trading in individually-purchased TIPS. As explained in my previous article: The Best & Less of Long-Short Equity Investing.
Post-2008 precaution. Put-sells have no third-party risk, but Put-buys do. The Options Clearing Corporation assures that each Option is well-backed. Nonetheless if leveraged to 200% of net worth as suggested by Mr. Cohen, and if over-depending on Put-buying for insurance, then in a serious market crash during which financial institutions receive no bailouts, there is a slight theoretical possibility of losing 100% of net worth.
Therefore post-2008 and with many voters understandably against any additional bailouts--not to mention the fact that Put-selling engenders possibilities for mathematical error--perhaps we should be more circumspect than Mr. Cohen's 2003 book about suggesting 200% leverage for the average investor's life savings. You might also want to consider diversifying your hedging instruments with trend-following, individually-traded TIPS and perhaps Bear Call Spreads.
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