Sell naked put options to lift returns

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The rally in global equity markets is making it very challenging for regular and professional investors alike to find reasonably priced opportunities.

The problem is that most of the fundamentally strong companies in today’s market environment are trading at or above their net asset values (NAVs), a common metric used to determine a company’s worth by calculating the discounted cash flow of its estimated future operations.

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This leaves a traditional portfolio manager with few options. Essentially, all they can do is either wait for the stock to trade lower before buying or try to replace it with a different security.

However, it’s tough to find replacement securities in this market and sitting on the sidelines could prove costly should markets continue to move higher, especially for investors who are currently underweight.

This is where the derivatives markets can be particularly helpful. At TriVest, we actively use options as a less risky way of owning what we consider a fully priced-in stock, as well as a way of protecting the downside and adding tax-efficient income to our client portfolios.

There are numerous option strategies available to add value when used in conjunction with a model equity portfolio. Some are relatively complex, with multiple option contracts at different strike prices and dates, while some are quite straightforward and easy to understand.

One simple strategy is selling a put option on a security — referred to as a “naked put.”

For example, assume ABC Ltd. has an estimated NAV of $100 per share and is currently trading at $105. However, there happens to be a $90 six-month put option for ABC trading at $3.50.

An investment manager restricted from trading derivatives would have to sit this one out and either look for a replacement security, purchase ABC’s stock outright at $105, or wait for the share price to drop before purchasing it.

For those not restricted, a possible strategy would be to write (i.e., sell) a put option.

This accomplishes two things. The portfolio receives additional cash income of $3.50 per share, equating to an attractive 3.3% yield for the six-month period (6.7% annualized). It is also typically taxed as a capital gain, which is much preferable to being taxed as income.

There are also two possible outcomes depending on what price ABC is trading at six months out.

If the stock is trading above $90, there is no additional transaction. The portfolio keeps the $3.50 per share and can proceed to write another six-month put option for further income if desirable.

If the stock is trading below $90, the portfolio manager is required to buy ABC at $90 for the portfolio and gets to keep the $3.50 per share from the option writing.

The end result, excluding commissions, is that the portfolio now owns ABC at an effective cost base of $86.50.

Assuming the $100 NAV of ABC is still correct, the stock has now been purchased at an attractive 13.5% discount to its NAV.

You may be wondering why this strategy isn’t an industry standard if it works so well.

First, it is an intensive process and large firms find it quite difficult to properly implement and manage effective strategies primarily due to the sheer number of their clients.

Second, the Montreal Exchange, where Canadian options are traded, often does not provide enough liquidity for large positions to be traded.

Finally, some investment professionals are not informed enough on the use of derivatives and/or are restricted from trading them and therefore do not use them.

Martin Pelletier, CFA, is a portfolio manager at Calgary-based TriVest Wealth Counsel Ltd.