The Mosaic Company (Photo credit: Wikipedia)
In my last article, I wrote about the covered call strategy and how tothink about enhancing returns in a risk-defined manner. A related strategy, or one that some would look at as the first step in getting themselves into the covered call strategy, is the covered put.
Purchasing a put gives the right to exercise the option whenever we would like, but in this strategy we are selling a put. In other words, we are going to take the obligation to purchase the stock (it can be put to us) at the strike price that we sold.
Let’s dig a little deeper with a real-life example, as it is always helpful to learn from actual situations.
On the morning of June 6, 2012, the stock of agricultural nutrients producer Mosaic (MOS) was trading at $47.26, as you can see in the chart below. Say you did your analysis and decided that you would be very happy to pick up the stock at $45, how could you do so?
You could put in a $45 bid and hope the stock traded down to that level, but in that scenario your money is not really working for you and there are other ways to achieve the same objective of purchasing the stock at a price you designate that also has the potential to enhance your returns. As with any strategy there are some unique risks to this that we will touch on, but being aware of the fact that there are different routes to the same objective will help you make improved decisions.
If we look at the chart, we see with MOS trading at $47.26 on June 6 the July $45 put (highlighted above) was trading at approximately $2.00 (bid $1.95 and offer $2.02, but to make the math simple we’ll use a round number).
Selling the July $45 put for $2 gives another investor the right to put the stock to us at $45, or in other words, commit to buying the stock at $45. If the stock closes below that price on expiration day – 44 calendar days away as shown in the chart above – it will automatically be put to us.
The primary benefit of such a strategy is that if the option expires below $45 you will own the stock after taking in the $2 premium. In other words, your effective break-even price is $43, or 4.5% below where the stock is trading June 6. (Note that our example does not address transaction costs, including commissions, contract fees and assignment fees. These must be considered for an accurate assessment of actual profit/loss.)
This is an important feature as it allows you as a trader to have “wiggle room,” allowing an opportunity to be wrong on a trade’s direction and still have a chance to make money. That is, if the stock were to break down from its’ current price and still close above $45 on expiration day, you still get to keep the $2 in premium that you collected when you first sold the put.
Another thing that is nice to know: all options are probabilities so we can estimate the likelihood of an option being in or out of the money on expiration at the time we sell it. At the moment this trade was executed, based on the current options pricing, there was a better than 58% probability of the option being out of the money.
The upshot of all this is that you would be selling a put with a nice probability that you would not get to buy the stock, but would keep the $2 premium from selling the option. In other words, your money is working for you by reeling in that premium rather than just sitting there waiting for the stock to approach the desired level.
There are two primary drawbacks to such a strategy. First, if you change your mind and do not want to buy the stock, you may have to pay more for the put than you originally received in premium. The second is that you are put the stock and the stock goes straight down. However, at least if you go straight down your entry point was cheaper than if you purchased the stock outright.
In summary, this is another way to think about purchasing stocks using options. If the stock moves straight up, at least you got to keep the premium from the put you sold. If the stock goes down and finishes above the strike, you get to keep the premium. If the stock goes down you have a lower entry point than if you just purchased the stock outright. As long as you know the potential risks and reward going in, the covered put can be a great strategy in your toolbox.
Options involve risk and are not suitable for all investors. Before trading options, please read Characteristics and Risks of Standardized Options. Commentary and examples provided for educational purposes only. Should not be considered a recommendation for any specific security or strategy. Probability analysis results are theoretical in nature, not guaranteed, and do not reflect any degree of certainty of an event occurring. At TD Ameritrade the online commission costs would be $9.99, plus $0.75 per contract. Exercise or assignment fees would be $19.99.
