By Kirk Spano
Most investors own some mix of stocks, mutual funds and exchange traded funds. In building an equity asset allocation for their portfolio, without knowing it, or simply accepting it, they are taking about 100% of the risk of the equity markets. There is however a safer option for building the equity portion of your portfolio over time versus buying investments at market prices.
If you are an investor who would like to acquire shares in a particular stock or exchange traded fund, but want to wait for a lower entry price, then cash secured puts might be for you. A cash secured put is a simple transaction whereby you sell a put option on a particular underlying security which obligates you during a time frame to buy that security if it trades at or below the price that you specify, called the strike price. You are not obligated to buy if the price does not drop to the strike price you have specified.
What is doubly wonderful about this approach, besides setting a low buy price on a security you like, is that you get paid a premium for selling the put option to another market participant. For the other investor, it is a form of insurance on their holdings. In essence you are their insurance company.
What do we know about insurance companies with good underwriting? They generally make money over time. So there is the trick. Using cash secured puts, like stock and ETF investing, still comes down to doing good fundamental research, akin to underwriting at an insurance company.
By selling a cash secured put, you are adding a margin of safety versus outright buying a stock or ETF at today's prices because you have set a potential purchase price below today's price (much like setting a limit order) and received premium income adding to your cushion.
Let's take a look at two potential transactions. A couple of weeks ago I discussed that at recent share price levels I liked General Electric /zigman2/quotes/208495069/composite GE -2.09% for both its growth and dividend potential. Suppose that I was only willing to buy GE at $14 per share, which is a couple of pennies below their 52 week low, but it is trading closer to $16 now. I could hold some cash in my account and set a $14 limit order on GE and wait for it to hit my price — if it ever did. In this scenario though, I do not get paid while I wait, and my money market rate right now is lousy to boot. This is the definition of dead money.
My other option is to sell cash secured puts on GE. Looking at the options calendar I see that GE has puts available in March. If I sell a put now (you will have to check prices when you read this), I can receive .38 per share (in 100 share lots) of GE that I am willing to commit to buying if the price of GE drops to $14 by the third Friday in March. Generally, if these options exercise, it will occur on the expiration date of the contract, though that is not required and sometimes options will exercise anytime during the contract time frame.
By receiving .38 per share, I am making 2.7% for about a 3 month commitment to hold cash in my account for a potential purchase of GE. While this is not a superstar return, if you are concerned about risk and only want to buy at prices you consider low, this is a nice approach. Consider how often these premiums can be collected in a year and that you will generally be buying at low prices when you do buy. You should see why this is an interesting strategy for less aggressive equity investors.
Another stock, which I discussed on Fox Business a few weeks ago is Veolia . Veolia is the largest water infrastructure company in the world, has other profitable businesses and is a generous dividend payer. This is a more aggressive pick given the turmoil in Europe, but something to consider, especially since Veolia has announced how they are going to pay down some of their debt .
Right now VE is trading in the $11s. If you believe we are near a bottom, but want a little more margin of safety from volatility and uncertainty, selling puts might be the right play. Looking at the options calendar I see that I can sell a put with a strike price of $10 for April expiration and get .60 per share. That is a 6% return for about a four month commitment to hold cash for a potential purchase of VE at what would be an all time low price per share.
Selling puts comes with the same general risks of equity investing, so never forget that this is an equity strategy. However, because you are setting lower buy prices and receiving premium income, you are incrementally adding margin of safety with each transaction versus buying equities at market prices today. If you believe in Armageddon scenarios, this strategy, like other equity strategies, should be avoided or used sparingly until you are more comfortable with equity investments again.
To learn more about cash secured puts I suggest visiting the Chicago Board of Options Exchange website /zigman2/quotes/208166986/composite CBOE -1.43% which has a wonderful learning library. In a few days, after you have reviewed their materials, I will be back with another dividend paying company that I think this strategy can be applied to.
DISCLOSURE: Kirk Spano has positions in VE and GE.