In a significant market downturn, bearish sentiment, if not outright fear, can drive down the share price of good companies rather drastically. When the market is in a sustained selling mood, there can be a substantial disconnect between the long-term fundamentals and the technical price action we see on the chart.
THE TEMPTATION TO BOTTOM FISH
What can we do when good companies are trading at what appear to be bargain prices? We could stick our toe in the water and buy shares. But what if we’re wrong about whether a bottom in the share price is in place? Or what if the stock takes a very long time to build a base and goes nowhere for an extended period?
SELLING PUTS
Rather than buying shares, we could sell put options instead. It’s a strategy famously used by Warren Buffett to acquire shares at a discount.
First, a quick review of put options. Someone who owns or is long a put has paid a premium to have the right, but not the obligation, to sell shares to the counterparty at the strike price. But that right exists only until the option expires.
The counterparty who has sold, or is short on a put, has an obligation to buy shares at the strike price. That obligation is eliminated when the option expires, and the put seller gets to keep the premium collected whether they have shares put to them or not.
Although selling puts can be a way to acquire shares at a discount, traders (as opposed to investors) may just be interested in collecting the put premium as an income strategy.
RULES TO REMEMBER
We must like the stock at or around the strike price and believe it will recover over time. Even if we’re just selling puts to collect premiums, keep in mind that we could end up owning shares.
Of course, there must be options available on the stock. The options should have good liquidity – decent volume, open interest, and bid/ask spreads that aren’t too wide. The strike prices near the current share price should have hundreds, if not thousands, of open interest contracts. The bid/ask spreads on the options should be just a few pennies wide. It’s usually a good sign of option liquidity if weekly, not just monthly, options are available.
WHAT MAKES A GOOD CANDIDATE?
Look for companies with a long history of good earnings that have rebounded after many economic cycles. The company sells a product or service that will likely remain in demand for the foreseeable future. (No buggy whip manufacturers.) A good candidate will likely weather the current storm and come out okay when the economy recovers.
Ideally, the share price is under $25, preferably under $20. At that price level and below, the option premiums relative to the share price make for efficient use of capital and an attractive return on risk.
EXAMPLE SETUP
Say company “ABC” was trading for $34 a share before the general market selloff but now is trading for roughly half that at $15.60. There is blood in the streets, but overall sentiment may be improving.
The price action on the chart shows some tentative signs of bottoming. A gap up with increased volume is a good sign. A recent earnings report that wasn’t as bad as expected is another good sign.
In this example, the premium for the $15 put is $1.20 for an expiration 42 days away. While the $15 strike is currently out-of-the-money (OTM), if we had shares put to us at $15, our cost basis would be $15 – $1.20, or $13.80.
If the shares were trading at $14 at expiration, we’d have shares put to us. We could turn around and sell those shares at $14 and have a profit of $0.20. But we would still be ahead on the trade with a profit.
As options sellers, we’re selling time value that decays as the expiration date approaches. We know that regardless of what happens with the share price, the time value we sold will be $0 at expiration.
As an alternative to risking assignment, we could roll the trade forward rather than wait for shares to be put for us. We could buy back the option on or near the expiration date and sell another option further out in time. We can typically do that for a net credit. In this example, we might be able to collect another $1 in premium. So now our risk in the trade is reduced to $15 – $1.20 – $1.00 = $12.80.
SUMMARY
Put selling can be a savvy way to go bottom-fishing for good stocks, either to acquire shares at a discount or just collect option premiums. We can make a profit if the share price goes up, sideways, or even down a bit. Selling puts gives us a way to get paid while we wait for the share price to recover.