Put Options: Sell Something You Don't Actually Own

This article published with permission from InvestmentU.com.

If you don’t know how to make money in the market today and you can’t see a clear direction or trend, one option for generating income is to sell something you don’t own.

Yes, you did read that right. Sell something you don’t have

put options.

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Since mid-September, the market has gone into consolidation mode, which has presented us with some opportunities to buy stock in good companies at better prices than we could get in August. The only problem is that we don’t have a four-week crystal ball.

If we have confidence in company fundamentals, in time, earnings and assets will grow and support growth in the stock price.

But what about tomorrow?

Many things can happen in the short term, and by selling put options you receive extra premium to offer cushion that you don’t receive by buying shares outright. This extra cushion can allow you to invest more comfortably in hot trends with less risk, or get paid to wait for an upcoming event. By allowing existing owners to offload some of the volatility in their portfolios, it’s like starting your own insurance company.

Be your own insurance company

By selling puts, you’re essentially starting the “Joe Investor Insurance Company,” where you allow other investors to offload some of their portfolio risk for a fee. Consider this example:

You have a long-time horizon and would like to take advantage of the recent sell-off in companies that have been hurt by Hurricane Sandy. You

know that earnings in the coming quarter will be difficult because of this one-time event, but you also realize that in future quarters, earnings will rebound. You don’t want to sit in front of your computer trying to catch the bottom, but would still like to participate. So you sell a put on Allstate (NYSE: ALL), a company that has rallied 7% from its recent post-Sandy low. It’s also currently selling below its stated book value of $43.14 per share.

Selling a put that expires on April 20 with a $40 strike price would provide you with $1.86 of income for selling a six-month insurance policy. At first glance, $1.86 may not seem like much, but that’s a 4.5% return

which looks pretty good compared to holding cash in an investment account. And even if the contract gets exercised, your cost basis is $38.14 per share

11.6% below the stated book value.

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Invest in hot trends with less risk

Long-term investors can also sell puts to participate in hot trends, but with considerably less risk. Consider LinkedIn (NYSE: LNKD). The company has been steadily growing profits since its IPO, but because of the stock price volatility, individual investors have needed a strong stomach. Selling puts provides additional cushion to smooth out this volatility.

LinkedIn puts with a strike price of $90 and an expiration date in January 2014, more than one year out, are selling for $12. This would equate to an 11% return on the underlying stock even if the share price doesn’t appreciate at all in the next year.

Considering that the company is expected to grow profits by 77% next year, this is a safer way to participate in the rapidly growing trend of paid social media than buying the equity outright.

The reason for this premium is that there’s risk, if the stock falls below the strike price at any point during the contract, you could be forced to buy the stock. For this reason, you must be ready to own the stock at your reduced purchase price of $78 if the share price falls. Also remember, options are only sold in round lots (1 contract = 100 shares) so make sure you can afford to buy 100 shares of the stock and that it’s a stock you wouldn’t mind owning.

Getting paid to wait

You can also use naked put selling to earn income while you wait for some future catalyst. And Crown Castle International (NYSE: CCI) is an example of a company with strong fundamentals and a potentially positive financial event coming up more than a year out.

CCI is expected to change its fundamental corporate structure and reform itself as a Real Estate Investment Trust (REIT) in 2014 after the benefit from its net operating losses are fully used as tax shelters. Under this new corporate structure, the company would be required to pay out 90% of its pretax income and may expand the shareholder base, possibly creating more demand for its shares as a new type of investor is attracted.

This is an intriguing event that may boost the share price, but it isn’t occurring today. The question is whether the stock price will continue to appreciate over the next year. If you would like to participate in the company, one option is to sell puts expiring in June 2013 with a $65 strike price. These can be sold at $3.70, which represents 5.5% of the current stock price, but the strike is about $2.30 below the current level. Again, if the price falls below that level you could be forced to buy 100 shares per option contract. But by sticking to solid companies that you’d like to own at cheaper prices, you won’t be stuck with a stock you don’t want.

Selling puts provides investors with a premium that pays you to wait for a position to begin to work, or the cushion to soften a potentially volatile position. It’s also a good, cheap way to use your margin account. Remember, you haven’t actually made money until a position is sold, and in this case, you’re making the sale upfront and letting the volatility disappear over time.

David Eller is part of the research team at InvestmentU.com.