Why I’m selling puts… and what is a put?
How the heck can a real estate company which is losing money every day be one of my favourite stocks at the moment? Seritage Growth Properties is the stock, and I won’t do any form of deep dive into the company in this blog. The business has already been covered extensively by this excellent series of youtube videos:
The premise of this stock is simple though. They own lots of properties and have lots of debt. They are not generating enough cash to meet the repayments for their debt – so they are on a time limit. In redeveloping some of the properties they hope to increase the revenue per square foot to the extent that they will not only be able to meet their debt repayments, but actually pay it off and continue to generate revenue into the future. They are selling off some of their ‘lessor value’ properties to cover costs of redevelopment and buy themselves time. Their total assets are currently worth far more than their shares are trading for (roughly per share their asset value is $30 – $40 depending on how you value it). The key questions are – will they run out of time, and will the redevelopments earn enough revenue to be profitable in the future? They are also in the middle of exploring whether to sell the whole company at once. This process is just starting and could mean the company is taken private, and shareholders are paid out for their ownership stake. The value of this payout is unknown, but management have released guidance of high teens to high twenties as a target. Up to you whether you think this is achievable.
The reason it is one of my favourites currently is because it is a stock which is allowing me to sell puts. Say what? A put…?
I’m not big on options. They are complicated and by far one of the riskier ways to try and make money on stocks.
Many professionals have extremely complex strategies to use options to make money. I don’t profess to understand these and to be frank this is not a real priority for my learning.
If I do end up learning more on this topic and become more comfortable with options I won’t rule out doing more in future. I probably won’t, but I don’t want to put something in writing that goes out on the interweb which locks me in to a position on something when I might change my mind. I am open to changing my mind as new information becomes available to me.
Despite all this I have started ‘selling puts’ over the last six months. A simple overview of options is that there are two types – calls and puts. Both calls and puts can either be bought or sold, so there are four variations.
An option is a contract between the buyer and seller and is typically for 100 shares (ie 1 put is worth 100 shares). The contract allows for the purchase or sale of the 100 shares at a set price (strike price), on, or before a certain date (expiry date). The buyer of the contract pays the seller an up-front fee for the contract (a premium). Note here you can get options contracts for other assets as well, but we focus on shares here.
Call buying gives the buyer the option to buy 100 shares at a set price to the seller on, or before a set date (if the price ends up above the strike). By paying the premium the call buyer has an opportunity to purchase 100 shares even if the price skyrockets because they have already established an agreed maximum price they would pay to purchase the shares.
Put buying gives the buyer the option to sell 100 shares at a set price to the seller on, or before a set date (if the price ends up below the strike). By paying the premium the put buyer has a safety net if the shares they are selling on drop significantly in price because they have already established an agreed minimum price they can sell for.
This is how selling a put works in practical terms for my strategy.
I find the stock I really like which is overpriced in the current market. I figure out the value I believe it is worth (and then apply a further margin of safety in case any of my calculations are wrong). That is the strike price I would like to put into the put.
I search through different time periods using the strike price above to find a reasonable premium that someone is likely to pay me. For this stage I am balancing the date of expiry (time that the agreement is in place), with the premium (the up-front cost that the buyer pays to you as the seller). This is cash, to you, as soon as they buy your put.
Once the put is sold, I receive the premium. Now I wait. If on the date of expiry the share price is less than the strike price, the buyer of the put can force me to buy 100 shares at the strike price (ie he would make a profit). If on the date of expiry the share price is more than the strike price we agreed, the contract is worthless and disappears (but I keep the premium they paid me at the beginning).
What could go wrong?
Well this strategy ties up money into a trade which then means it is unavailable to use for other things until the trade expires. This is because I refuse to take margin (effectively a loan), to run these trades. You should too. The worst blow ups occur when people use leverage to place trades. Don’t do it. Ever. By doing this though if a fantastic opportunity comes across I can’t use the cash to do other things.
If the stock that I have the put on drops far below the strike price (price of purchase) that has been set, then I would be forced into paying more for the 100 shares than I could buy in the open market and therefore be losing money on it.
It is worth noting that I am limited by which stocks I can do this strategy with because of the price of the 100 shares that you might be forced to buy. Because a single put is worth 100 shares, stocks that are trading at high prices will price me out of the market straight away. I don’t have tens of thousands of dollars to be used in this way so naturally if a stock is trading at $50, that means one put is worth $5,000! I don’t have that kind of money to be tied up!
So why the hell am I selling a put? The thought process is this:
1. There are limited numbers of good opportunities in the market right now to put my money towards.
2. By using shorter term puts, having at least two single puts (remember a single put is worth 100 shares) and rolling them (so selling one for expiry end of March, one end of May), I can balance the risk of having all my money tied up for long periods.
3. The most important part of this strategy to counter the risk of the price dropping far below the strike price is that I actually want to own the stock I am selling puts on and based on my valuation I would buy the stock in the open market if it fell to the level of the strike price anyway. This is the most important factor because it means that the second downside mentioned above is completely irrelevant as I would have just bought the stock when it reached the strike price and still have lost the exact same amount of money but not received the premium from the buyer.
4. The other scenario which is possible and can be extremely frustrating is that during the time of having the put contract in place the share price might drop well below the strike price, but by the time the contract comes for expiry has risen again above it. This means that you do miss out on the shares at a price you wanted, but actually had the opportunity to buy them during that time period. This is perhaps the worst case scenario in the approach I take to selling puts.
You should also note that not all stocks have options available, and/or the options pricing does not make it worth doing.
You can calculate the equivalent annual return on the amount you have tied up by selling a put if you want to compare that money to say having it in a term deposit or savings account. This is done by extrapolating the number of days of the contract out to a year, the amount of money made in premium (the price x the 100 shares), and the amount of total funds you are tying up in the trade. As an example:
A 200 day put sold where the strike price is $10, and the amount earned is .9. If the put expires and the price is above $10 the person who bought the put won’t force me to buy the 100 shares. That means I keep the $90 they paid me (.9 x 100 shares), but that I had $1000 tied up for 200 days that I couldn’t use for something else. This would equate over a full year to be a 16.8% return on the $1000 that was tied up in this trade.
Some recent returns I have been seeing for my trades are between 18-25% annualized return.
It can be a strategy that tests your patience and nerves. You might just want to buy the stock outright, You might just want to buy a call (which gives you an immediate loss, but potential future gain). You might have miscalculated the value of the stock and be stuck forced to purchase a whole bunch of shares you decide later you don’t want. The price might hover around the strike price for the entire period of the contract and you don’t even know how you feel about it. All of this is possible and probable if you employ this strategy. I just try to keep reminding myself that “Patience is bitter, but its fruit is sweet.” Aristotle.
Will the put strategy be a good one long term? Will the stock actually do well? Who knows. But for the moment I am quite happy with generating some return on cash that would otherwise be doing nothing, and hey, if I get to purchase some shares of the company at prices I probably would have bought anyway – well all the better.