Blog 11 - Generating Opportunistic Alpha

Selling Puts: Modern-Day Treasure Hunting

"Opportunity is missed by most people because it is dressed in overalls and looks like work."— Thomas Edison

Digging for buried treasure may sound like work, but it should have universal appeal. Instead of spending uncomfortable hours combing an arid desert for valuable artifacts, the modern-day equivalent of selling Puts requires nothing more than vigilance, judgment, and access to a computer.

The target treasures? Quality stocks that have recently incurred a discount (for non-material reasons), on which to selectively sell Put contracts.

Even during years of significant gains, most growth stocks will fluctuate in value up to 30%-40% annually (Figure 1). If nothing material has prevailed (Table 11.1), selectively selling Put contracts on recently discounted non-core stocks offers the opportunity to generate alpha returns as most stocks share prices eventually recover. While this is a leveraging strategy requiring margin capacity, it's considered passive income without interest costs. In fact, speculators pay the seller (you) a premium for writing these contracts.

Figure 1 Source: JPMorgan

Table 11.1: Material vs Non-Material Matters

Non-Material Matters

Non-material issues are typically transient and more often associated with operational issues and traditional business cycles. They often surface during quarterly earnings announcements. Averaging down should still be a function of the corporation's outlook, maintaining competitive advantages within its industry, and confidence in its leadership.

Material Matters

Companies experiencing material problems require deal-breaker consideration. The company will likely need transformation. Yet, even with a major trauma, there could still be life for the business if leadership handles the situation well. However, such transitions often require outside influences and resources.

Material matters managed poorly result in value traps⁴. They require your best detective skills. Triangulate with several sources to confirm or deny suspicions. Hold-off on selling any Put contracts until the corporation publicly announces its action plan to address deficiencies. If doubts linger, better to review new choices.

Sell High. Buy Low.

Instead of buying low and selling higher, selling Put contracts at higher prices and buying them back at a depreciated price is the same winning formula. So how does this work?

Writing a cash-covered¹ Put option² potentially obligates the seller (you) to buy a set number of shares at a set price—the Strike Price—by an expiration date (all terms set by the seller) in exchange for a premium paid by the buyer.

Buyers of Put contracts are speculating that the underlying stock's share price will decline by the contract maturity date (bearish). The Put seller (you) is optimistic about a recovery in the price of the underlying stock—so much that the contract will fail. With the long-term trend of the stock market being positive, writing Put contracts already favors the seller.

The Odds Favor the Seller

According to the CBOE³, statistically on average only 10% of options contracts are ever exercised and another 30-35% regularly expire out-of-the-money worthless. This provides a Put writer the opportunity to generate premiums with only a modest chance of having to own the underlying shares. Since the market rises annually approximately 74%⁴ of the time, selling the natural decay of Put contracts is a low-risk way to generate extra returns.

Success Means Designing for Failure

Success in writing a Put contract is to set the terms in a way that will have a high probability of failure. In other words, success means choosing contract terms for which you receive a premium but are never forced to purchase the underlying shares. To achieve this, here are 5 variables to factor in when writing a Put contract:

1. Stick to Quality

Only sell contracts on quality growth stocks not already held in your core portfolio (Tier 1). Make sure they surpass most of your search criteria, have respected management teams and fit with your current core portfolio diversification model (sector, industry, geographic locale, and market cap). After all, occasionally, a contract will be exercised and the stock position will become part of your core portfolio.

2. Wait for the Discount

Wait until stock discounts of 20%+ (for non-material reasons). Usually, these will be announced in the media on the day. Each of the four corporate reporting seasons offers prime opportunities to sell contracts on earnings surprises.

3. Zone of Confidence (Function of 2 Factors)

Choosing a Strike Price depends upon both:

• Your Risk Tolerance (see Table 11.2), and

• Your Expectation for a Recovery of the targeted stock—what Strike Price would be reasonable to choose given your degree of confidence in the underlying share price to regain it's growth momentum.

Table 11.2

4. Give It Time

Choose a contract duration from 3-18 months to give the business a long enough time horizon to regain its growth pattern. Longer if you are risk averse or if you believe that the share price will need more time to recover, assuming that the discount is not due to a material matter.

X Marks the Spot

Once a target stock opportunity is identified, do your research. Use your 19 filters to determine a stock's worthiness for inclusion in your portfolio. Then set the contract terms: OTM, ATM, or ITM, and for how long.

Although more alpha can be generated by selling ITM contracts, likely the better sleep will come from less aggressive terms. Your call.

And If Exercised…

Not to worry. An exercised contract results in an exchange of equal value. The Put seller (you) will receive the contracted number of shares in exchange for cash. The new ACB will be the Strike Price. If you really didn't want to take possession of the shares, you can now sell Covered Calls to generate premiums until the position is eventually vacated from your portfolio. Win-win.

So, while the Tier 1 core stocks are working hard, and Tier 2 Covered Calls are earning regular low-risk income, now an investor can add supplementary growth from a diversified portfolio of time-laddered, value-priced Put contracts.

Welcome to modern-day treasure hunting!

Put Contracts as an Alternative Buy-In

Where an investor desires to conserve their cash, instead of buying new shares with cash, consider selling very short term Put contracts on a desired stock. If the underlying share price rises above the Strike Price at maturity, the contract will fail. Keep writing new contracts until a position is assigned to you. Until that happens, you keep all the premiums generated. Double win.

Relative to buying shares at market prices, this is a more effective way to buy shares. Just be mindful that each options contract is an obligation of 100 shares.

Put-Writing Tactics

Many treasures are "buried" in the capital markets. It requires vigilance to recognize them and diligence to deploy the appropriate contract terms. If you'd like to explore further into how and when to deploy your treasure-hunting skills, Chapter 19 of The Investing Oasis offers more detailed tactics and examples, including a schematic Put-Writing chart.

Don't be afraid to roll up your sleeves!

Summary

✓ Writing (Selling) Put contracts introduces leverage and requires margin capacity.

✓ Premiums are paid to the writer, irrespective of whether a contract is assigned.

✓ Selling Put contracts on recently discounted, non-core stocks can earn alpha as shares recover.

✓ No interest costs—rather, speculators pay premiums for taking on a potential obligation

✓ Success means designing for failure: Set difficult terms to minimize the chance of assignment.

✓ Five key variables: Quality, discount timing, strike price selection, duration, and risk tolerance.

✓ If exercised, you acquire quality shares at a discount with immediate Covered Call opportunities.

✓ Can be used as an alternative buy-in method to conserve cash.

✓ Statistically favorable to the Put Writer (Seller): Market rises 74% of the time. Only 10% of options contracts are exercised and 30-35% expire worthless.

"Money is the opposite of weather. Nobody talks about it, but everybody does something about it."— Rebecca Johnson

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Resources:

• The Investing Oasis - Chapter 19: "In Search of Buried Treasures"

Footnotes

1. Cash-covered: Having sufficient cash or margin capacity to purchase the shares if the contract is exercised ↩

2. Put option: A contract giving the buyer the right, but not the obligation, to sell shares at a specified price by a certain date ↩

3. Chicago Board Options Exchange ↩

4. Historical market data showing positive annual returns approximately 74% of the time ↩

Jay T. Mason, CFA, CFP manages the Oasis Growth Fund and is the author of

“The INVESTING OASIS: Contrarian Treasures in the Capital Markets Desert”,

as well as the blog series: ‘More Buck for Your Bang’.

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The Oasis Growth Fund is Series O of the Fieldhouse Pro Funds Inc trust series available by Offering Memorandum in Canada through select Financial Advisors. This education series is not intended as a solicitation for investment in the Oasis Growth Fund nor is it sponsored by Fieldhouse Capital Management Inc.