5 Put-Writing Candidates to Chew On

With stock prices still down substantially from their 2007 highs, volatility levels high, and a number of companies trading at their lowest valuations in a decade, selling ("writing") puts can provide you with an opportunity to collect option premiums on stocks you would be happy to buy if the shares were sold -- or "put" -- to you.

In general, you have three primary motivations when you write puts:

  • Income: To make money while waiting for your preferred buy price on a stock.
  • Advantage: To buy stocks at a lower net cost.
  • Profit: To earn income from stocks you believe will hold steady or only increase modestly.

Example, please
Let's say you think Research In Motion (Nasdaq: RIMM  ) is a promising stock, and you'd be happy to own it below $70, but it trades for over $75 -- a bit too high in your opinion. Rather than place a limit order and hope the stock falls below your limit price, you could consider selling September $70 puts at $2.70 per share (or $270 per contract).

By selling one put contract, you agree to buy 100 shares of Research In Motion for $70 per share (a potential $7,000 outlay) at any point up to September 18, 2009, when they expire at market close. In exchange for assuming downside risk, the put buyer (who is likely trying to limit his or her downside risk) will pay you $270 per contract.

If Research In Motion shares close above $70 on September 18, you simply keep the $270 premium you received and are no longer on the hook to buy the stock. On the other hand, if Research In Motion closes below $70 by expiration, you take ownership of the shares at a net cost of $6,730 ($70 strike price -- $2.70 per share premium received) -- a price you were happy with when you entered the trade. As long as the stock doesn't close below $67.30 by expiration, it's been a profitable trade.

Or course, the stock could plunge, and therein lies the largest risk of selling puts -- imagine selling Citigroup (NYSE: C  ) $20 puts last year when shares traded hands for $24 (currently $2.70)! Ouch.

That's why it's crucial to perform proper due diligence and value the underlying businesses when selling puts -- just as it is when you buy a stock outright. As stock-focused options traders, it's unwise to write puts on bad stocks just because a particular option pays well. You want to know what the underlying stock is really worth. This not only reduces your downside risk on the option trade, but it also makes you comfortable with the company you're on the hook to buy if shares fall below the strike price.

Screening for green
So how do you find a company that fits the bill? A great tool is the CAPS screener, which scours the CAPS community's 135,000 investors and 3.4 million stock picks (and counting) to find investment ideas. In addition to finding great stock ideas, we can also use it to find strong candidates for writing puts. I screened for stocks with:

  • CAPS ratings of four or five stars (to improve our odds for finding a good company)
  • Market caps of more than $750 million
  • Price-to-earnings ratios below 15 (the S&P 500 average)
  • Price-to-book ratios below 2 (the S&P 500 average)
  • 3-year betas greater than 1.2 (higher volatility equals higher option premiums)
  • Long-term debt-to-equity below 50%
  • Return on equity greater than 10%

This screen spit out 46 companies -- but for now, let's take a closer look at three of the more well-known businesses (keep in mind that these are not formal recommendations):

Company

Industry

CAPS Rating

Titanium Metals (NYSE: TIE  )

Industrial Metals

5 stars

Agrium (NYSE: AGU  )

Agricultural Chemicals

4 stars

Baker Hughes (NYSE: BHI  )

Oil & Gas Equipment and Services

5 stars

Tesoro (NYSE: TSO  )

Oil & Gas Refining & Marketing

4 stars

Lincoln Electric (Nasdaq: LECO  )

Industrial Goods

5 stars

Data from Motley Fool CAPS as of July 24, 2009.

At first glance, each of these companies shares some of the characteristics worth looking for when evaluating put-writing candidates. They're each free-cash-flow positive over the past 12 months, carry manageable levels of long-term debt, are undervalued relative to the market, and are supported by the CAPS community at large.

Next, let's check out some of the current put options available on the five stocks:

Company

Recent Share Price

Option Exp. Month

Strike Price

Premium (or Option's Bid)

Income % (Premium/Strike)

Break-Even Price on the Stock

Titanium Metals

$8.21

September

$7.50

$0.45

6.00%

$7.05

Agrium

$43.32

October

$40.00

$2.50

6.25%

$37.50

Baker Hughes

$40.69

October

$39.00

$2.40

6.15%

$36.60

Tesoro

$12.70

November

$11.00

$0.75

6.82%

$10.25

Lincoln Electric

$41.00

September

$40.00

$1.95

4.88%

$38.05

Data from Yahoo! Finance as of July 24, 2009.

Again, none of these should be taken as formal recommendations, but only as candidates for further research. That said, these are each worthy candidates. When we're looking at put options expiring in three months or less, we ideally want the strike price to be more than 4% below the current market price, and we want to receive a premium that's higher than 4% of the strike, together giving us a break-even price at least 8% below the current market price. With the sole exception of Lincoln Electric, which just fell short of meeting the second condition, each fulfills these conditions.

If any of these five put-writing candidates piques your interest, the next step is to do a business valuation to determine whether or not you'd be comfortable owning the stock at these potential strike prices.

Foolish bottom line
Options -- calls and puts -- sometimes get a bad rap for being "speculative" -- and they can be -- but used in the context of a stock-focused, long-term investment portfolio, they can help you improve your returns, reduce risk, and generate portfolio income.

Hopefully this article has helped shed some light on how to approach put writing. Want to learn more? We're launching a video series designed to get you up to speed on options basics. Just enter your email in the box below for access -- it's completely free.

Todd Wenning now returns you to your regularly scheduled program. He does not own shares of any company mentioned. Fossil is a Motley Fool Hidden Gems recommendation. The Fool's disclosure policy rocks on with its bad self.


Read/Post Comments (10) | Recommend This Article (26)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 24, 2009, at 3:06 PM, marcelitoS wrote:

    protalixs (Plx) is a company owned by the founders of TEVA .Its develops a new product for the treatement Gouche sikness and use vegetal products

    that are transformed to adapt it selves to the human body.PLX also develops products against chemical warfare, then ir seems the Company has a brigth future

  • Report this Comment On July 24, 2009, at 7:30 PM, kayakmastr wrote:

    This is a great analysis. But why did you pick these 5 over the others? I set my annual return criterion higher, at 20% or more, but all of your 5 picks meet this criterion.

  • Report this Comment On July 24, 2009, at 10:59 PM, marcosc wrote:

    I think this article is irresponsible. How can you suggest put writing right now after the massive run up?

    Where was this article back in March?

  • Report this Comment On July 25, 2009, at 4:14 PM, henryking54 wrote:

    Selling puts is a great way to blow up your portfolio. Hedge fund manager Victor Niederhoffer sold puts and lost all of his clients' money:

    http://www.tradersnarrative.com/rumor-vic-niederhoffer-blows...

    In the old days when the Fool actually cared about the financial well-being of its readership, the Fool routinely disparaged options as rank speculation:

    http://www.fool.com/news/foth/2002/foth020104.htm?

    Now the Gardners endorse options because they think they can make a few bucks selling subscriptions to gullible investors.

    The Fool has lost all of its integrity.

  • Report this Comment On July 26, 2009, at 6:14 AM, dmkap wrote:

    Henryking54, sorry, but I don't agree that that the Gardners are endorsing this strategy to make a few bucks. Any time the Motley Fool recommends selling puts, it always says "on the assumption you want to own the stock at such and such a price".

    It's true that you can blow up your portfolio by selling puts, but that won't happen if you keep the value of the purchase price in cash in your account. In other words, it is not riskier selling a RIMM 70 put as opposed to buying the stock outright at 70 or more. Actually it is more conservative, because you'd be buying the stock at 67 instead of 75. So if it crashes, you lost less money this way.

    The key is not to be greedy by selling puts when you don't have the cash to cover.

  • Report this Comment On July 26, 2009, at 9:08 AM, henryking54 wrote:

    dmkap,

    Did you read the link I provided on Bill Mann's article "Why We Avoid Options?" The Fool expressly told people repeatedly NOT to trade options. Here is an excerpt from Mann's article:

    "Let's examine why I believe individual investors are little more than the fodder for the options market. First of all, unlike equities, there is no wealth creation at all in options. As such, in any options trade, one of the two participants MUST be wrong.

    There is a fixed amount of value in options, and each one eventually expires. Actually, in options it is possible for both participants to lose, because neither may gain enough to cover broker commissions. Look at it this way: If there is a town where the only economic activity is for people to buy umbrellas from one another, eventually the whole town will in fact be broke. There is no way for options writing to generate value. Actually, it's a highly valuable line of business for the brokers -- they get to keep the vigorish on the options, leaving the options traders worse off collectively by several billion per year.

    That's the thing about options for most retail investors: It just makes something that is already so bloody complicated that much more so. We are already charged with the difficulty of determining what companies are good -- now we are trying to determine what the short- to medium-term price action will be as well, and to do so in a zero-sum game with a large and well-equipped group of professionals? Man, there is just no need. If you like a company and think the price is good, buy it. If the company seems expensive to you, sell it. Leave the casino games to the professionals, where game theory holds that in a field of players of equal ability, capital will eventually flow to the best capitalized. That, I dare say, is not you."

    http://www.fool.com/news/foth/2002/foth020104.htm?

  • Report this Comment On July 26, 2009, at 9:24 AM, henryking54 wrote:

    Here's another Fool article against options:

    "The truth is that most options expire unexercised and worthless. This is because options are really about buying time, not stocks. If you're really so sure that FishTop will rise -- and I'm skeptical that anyone can regularly predict the short-term moves of stocks -- just buy its stock, and leave options to the guy with the BMW. Chances are, he won't be driving it for long."

    http://www.fool.com/fribble/1999/fribble990210.htm

    And another:

    "As long-term investors, we don't place a lot of confidence in our abilities to predict price movements of a given stock over the next one to three months. We prefer to put our confidence in the wealth creation capabilities of outstanding businesses over a period of three to ten years. Therefore, it follows that using our investment capital to speculate (yes, that's the word for putting money in options) on price movements doesn't hold a lot of fascination for us."

    http://www.fool.com/portfolios/rulemaker/1999/rulemaker99111...

    And another:

    "The "official" Motley Fool position (as stated in the Motley Fool Investment Guide) on options is simple -- they are to be avoided, period. Why? Here are just a few reasons.

    1. Options generally have higher commission costs than stocks. Also, option commissions usually are more complicated to calculate than stock commissions.

    2. Options are very thinly traded (not many are traded every day), compared to stocks. Because of this, options have much higher spreads than stocks. The spread is the difference between the bid price (cost you could get on sale) and the ask price (cost you must pay to purchase). Stocks often have a spread that is less than 0.5%, while option spreads are frequently over 3%.

    3. Options expire within a limited time (less than 8-9 months normally, save for a certain type of options called LEAPS, which may not expire for up to 3 years).

    The three factors above run counter to the basic Foolish principles of long-term buy and hold and keeping trading costs at a minimum. Anyone who trades options will be giving a sizable chunk of money to brokers and will have to trade every six months or so (if not more).

    Most importantly:

    4. Options are very volatile. Thanks to leverage, an option's volatility will often be over four times that of the underlying stock (if a stock goes down about 10%, a "call" option might decline by about 40%. Remember the first week of the year? Multiply that by four!). As expiration approaches, that volatility will often become even greater. The options strategies discussed on the boards will frequently have 90% losses on individual positions, and often will lose 50% or more for the entire portfolio. Not "might lose," but "will lose."

    http://www.fool.com/workshop/2000/workshop000118.htm?

  • Report this Comment On July 26, 2009, at 9:29 AM, daveosome wrote:

    Much as I like Bill Mann, I think he was wrong in that article. Put selling is a great example of a win-win for both participants. One person is selling insurance to the other. Can you say that the person who bought the put "lost" if the stock price goes up? No, they protected their assets against losses. Can you say that the person who sold the put "lost" if the stock price goes down? No, they bought the stock they wanted to buy at a price that's lower than they could have gotten on the day they decided to buy the stock (or sell the put, actually).

    People who buy insurance aren't losers if their house doesn't burn down.

  • Report this Comment On July 26, 2009, at 8:46 PM, PaulEngr wrote:

    To those who are decrying TMF's mere MENTION of options: hogwash. TMF shorted Sirius Satellite way back in the late 90's as I recall, back with the "real money portfolios". Options CAN be very dangerous because they can have unlimited risk, and can amplify the profit/loss from stocks dramatically through increasing your leverage (amount of money you have on the table). Options does have two additional concepts that in general stocks don't inherently have: the concept of time, and the concept of leverage.

    Options can amplify the risk/reward ratio, or diminish it. They can make stocks that are stable (not moving) into profits, or profit from volatility. Generally with trading stocks, time is your ally. With options, time can be either an ally or an enemy.

    For the record, I wouldn't use this particular strategy as described. Instead of selling a $7.50 TIE put for instance, I'd sell the $5.00 put. It's currently selling for $0.10. I'm paying pretty close to that in brokerage fees, so effectively the put is "free" (I neither get nor receive anything for it).

  • Report this Comment On July 27, 2009, at 1:26 PM, ValueIsValuable wrote:

    Note that many brokerage firms will require a higher level of account equity in order to allow an investor to write calls/puts. Also, they will require an investor to have experience with options (i.e. understand what they are getting themselves into) before they allow sales of these derivatives.

    Ironically, most firms will allow an investor to buy calls and puts right out of the gate.

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