The dilemma: buy stock or sell puts?

by Wayne Ferbert on November 25th, 2013

When it comes to stocks, I am not a ‘Stock Picker’. That particular moniker is reserved for the investor that relies on his stock picks to beat the market. That doesn’t describe our indexed hedging approach to the market – not at all.
 
But I can totally understand the motivation of the stock picker: the belief that thru analysis of a particular stock, you can buy it low and sell it high. I get it.
 
For the person that excels at it, there are great rewards. The problem is I have yet to meet a money manager that excels at it for very long or with the right level of consistency and predictability. As a result, we focus on indexes.
 
But I do occasionally buy a stock that I think is under-valued with the plan to sell it for a higher price. I have bought General Electric, Microsoft, Bank of America, and Apple in the last 5 years – all on dips to levels that didn’t seem to appreciate the real underlying strength of the company. And I help clients buy stock all of the time when they have a strong conviction.
 
But if you are a stock picker, what do you look to buy at these remarkably high levels in the market today? If you are putting new money to work, where do you deploy it?
 
I have a recommendation for the stock picker in you: sell ATM and OTM puts on the stocks you like to represent your entry to the stock. We have discussed this strategy on this site before – but not in quite a while. Let’s recap it.
 
You have a stock you like – but wouldn’t mind owning it a little cheaper than where it trades today. In other words, you’d like it even more if it was ‘on sale’. So, you sell a put that expires in one of the near months at a strike price roughly 2% or 3% out of the money. Or, if you REALLY like the stock, you sell the strike that is right AT THE MONEY.
 
If the stock dips and is trading below the strike price at expiration, you will be triggered in to buying the stock. If it doesn’t, then you get to keep the put premium as profit. And, you can look to sell another put again – assuming the stock is still one you would like to own.
 
How has that strategy worked in 2012 and 2013? Well, in wild bull markets like this one, you will certainly lag the market. Your puts would have expired worthless and generated profits over and over again – but the market is up 25% this year and over 50% in two years. So, you would be looking back with certainly less return than the market – more than likely.
 
The factors that would have driven your returns: the volatility of the stocks you picked, how far out of the money you sold your calls, and avoiding stocks that corrected in the last 2 years.
 
This kind of put selling strategy on individual stocks could have easily generated 10% to 12% annual returns this year – even with volatility at these incredibly low levels. In fact, depending on the stock, you could sell premium to generate even 15%-20% returns. But that is clearly less than the market returns in this bull market.
 
So, with volatility at low levels and the market at all-time highs, would you keep doing this? I think you can – just be a judicious stock picker and only pick prices for your strikes that you know you would be a happy owner of the stock.
 
HOWEVER, I would NOT deploy this strategy without a broad market hedge underneath it. If you can consistently generate these 10-12% returns selling puts on quality stocks, then why not purchase some downside puts in the SPY or SPX to hedge your downside.

With volatility at all time lows, you can purchase puts about 10% out-of-the-money for only around 2-3% annual cost right now. Go ahead and purchase that protection to be safe – then start selling those puts even closer to the money knowing you have downside protection in your portfolio.  You are generating enough premium to afford that kind of 'insurance premium' anyway.


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