“Shoppers: We have a Blue-Light Special going on right now…”
If you’re as old as me (mid-50s), you might just recognize that from Kmart.
Does Kmart still exist? I don’t know. I haven’t seen one in 30 or more years. But that’s neither here nor there. Because this isn’t about Kmart as much as it’s about buying stuff on sale.
By “stuff,” I mean stocks in this case.
Last Tuesday, I wrote to you about my landlord here in Prague returning to work on oil rigs in the North Sea and why I see that as a precursor to higher oil prices this year. I’m saying we see oil at $100 a barrel before 2021 is over.
As part of that dispatch, I noted that I tried to nab Exxon shares in November using a relatively safe options strategy, and that I would be back to share that strategy with you…
Tah-dah! I am back with that strategy.
It’s called “selling naked puts.”
Don’t worry, this will be simple, part of what I am calling my Investing 411 series of columns that I will bring to you in the coming weeks. These will be “get to know you” columns to help you better understand in easy-to-grasp terms all the stuff that happens with investing. My goal is simple: To demonstrate that the strategies necessary for thriving and growing your wealth on Wall Street can, basically, be drawn with a crayon.
So…selling naked put options.
Instead of describing what that is in trading gobbledygook, let me tell you a story about a trade I made last spring. This is just an example, not a recommendation, because it’s too late now to make this trade.
In the wake of the COVID-19 sell-off last spring, I went hunting for high-quality companies that pay monster dividends. One I wanted was Altria, the tobacco giant. At the time, Altria shares were trading at close to $38. At that price, the annual dividend payment of $3.36 per share represented a chunky 8.8% yield. I’ll take that any day: Earning almost 9% a year to hold one of the world’s premier consumer product companies? Bring it on.
But this is where the blue-light special comes in.
I wanted the shares cheaper than that because I wanted to use the fear in the market to grab a yield closer to 10%.
To get that, however, I needed Altria to trade at $33.60 or below. Alas, I wasn’t convinced Altria would see that price again (and it never did). But, there was a way for me to artificially create that price by selling those naked put options.
First…an option in its simplest form is a contract with mutually agreed upon terms. I, Jeff, will buy from you, Reader, 100 shares of Amalgamated X & Co. for $Z per share on or before Y date. And you, Reader, agree to sell me those 100 shares for $Z on or before Y date. If Amalgamated X & Co. reaches $Z, then the contract is filled. If not, the contract expires worthless. I am out the amount of money I paid you for the contract, and you get to keep that money. (Like I said, very simple explanation. In practice, lots of permutations of this exist in the options market.)
There are two types of options: puts and calls. Puts are generally bearish (a bet that a stock will decline in price). Calls are generally bullish (a bet that a stock’s price rises).
See, when you sell a put option, as I did, you bring money into your account. Basically, another investor pays you to sell him an options contract.
The investor buys that put option because he thinks the price of the underlying stock will fall in value, and he wants to profit from that decline. Let’s say you, Reader, think Amalgamated X & Co., currently at $50, will fall below $45 on a bad earnings report. So, you buy that put option from me. And you’re right—weeks later, Amalgamated X tanks to $30 on bad earnings. Well, now you can go into the market and buy Amalgamated X for $30 and turn around and force me to buy those shares from you at $45, per our contract. You earn $15 per share, or $1,500 per contract.
If you’re wrong and Amalgamated X never sees $45, then I get to keep the money you paid me for selling you the contract.
In my case, an investor paid me $204 to sell him a contract betting that Altria would fall below $36. That equates to a payment of $2.04 for each of the 100 shares inside the contract.
If Altria fell to $36, that investor would force me to buy 100 shares of Altria at $36 each, or $3,600 per contract. If Altria never saw $36, well, the option would expire worthless for him, and I would keep the $204 he gave me.
In this instance, however, I was hoping Altria would slip to $36, because I wanted him to force me to buy those shares at $36 each. Here’s why: I already had $204 in my account from selling the option to him. If he forced me to buy the shares, then my real, out-of-pocket cost for Altria would be just $33.96 per share ($36 minus $2.04).
That would get me really close to my $33.60 target price.
And that’s just what happened. On the final day of the contract, Altria closed a hair south of $36, and the buyer of the put option I sold forced me to buy 100 Altria shares from him at $36 each. Again, I was happy to oblige because it fulfilled my mission of snapping up Altria at a nearly 10% yield (9.89%, to be exact).
Since then, Altria has climbed back to $49. Including my dividend payments, I’m up more than 50% in less than a year. Moreover, the company has increased its annual dividend payment to $3.44 per share. So, my dividend yield now is 10.1% per year going forward. (And Altria has a history of raising the dividend each year.)
This is the strategy I regularly use when I want to buy blue-chip, dividend-paying stocks. It’s my blue-light special strategy because it lets me get into stocks at a cheaper price. The upside, if the options aren’t exercised, then I keep the cash the buyer of the put option paid me. That’s what happened on two occasions with Exxon; the puts expired worthless. Though I never picked up the shares, I did make more than $1,000 on those trades.
I would never use this strategy, however, to buy flashy, belles of the ball—the stocks everyone loves and has pushed to extreme values. That’s because the risk is huge.
Take Tesla, for instance…
As I write this, Tesla trades at $693 per share. I might want to own Tesla at, say, $675 and I could sell a put option at that level and bring in $55 per share, right now, or $5,550 per contract. That means my real cost in Tesla would be just $620 ($675 I might have to pay later, minus the $55 I take in now).
However, Tesla is a hugely volatile stock, and if the market cracks or sours on technology, Tesla could very easily be a $200 stock—probably less. Yet, I own it at $620. I have huge losses. There’s just too much risk in that.
But when it comes to stable, blue chips, selling naked puts can be a fine way to shop Wall Street for those blue-light specials.
