It’s Friday night and feels like it’s about to snow here outside of DC. Great time for a scotch and to talk about income.
Everyone would like the opportunity to make extra income in their investment account. A few extra dollars for a vacation, maybe for a new car, or even for that nice single malt. Something over and above the return you are shooting for in your investment plan.
Selling puts is a great way to grab that extra income. But, before we dive into my three favorite put selling strategies, a brief aside from our lawyers. All options are dangerous, you could lose all your money (including some you don’t even use to buy or sell the option), and before trading options you should FULLY understand all the risks involved.
Back to our regularly scheduled program.
I like to sell puts, and sometimes use a bull put spread (selling one put and buying one further out of the money for protection), under three scenarios.
Boring, Range Bound Stocks
Stocks That Make Boring Products, and
Oil…Specifically USO (With a Bonus Lesson Thrown In)
In short, I want to sell puts on stocks that make me look like the kid in the picture here.
Let’s take a look at the three scenarios and a stock that falls into each category…I’ll use USO for oil.
Boring, Range Bound Stocks
One of my favorites in this category is AT&T (T). Take a look at the stock chart for 2012 through 2014. You can’t get more range bound than that. The stock traded in the low to mid $30’s over and over.
The stock gave you the opportunity to sell puts near support several times in that three year time span. I like to have a “stable” of these kinds of stock so that I always have one or two that is near support, and therefore offering an opportunity to sell puts.
Identify 5-10 boring, range bound stocks and you’ll always have one or two that is offering a way to gather income from selling puts. An additional benefit is that these types of stocks rarely fall apart, forcing you to either cover your put or take possession of the stock.
It also helps if your boring stock has a dividend. This will add an extra cushion if there are earnings surprises, etc. You can use the historical percentage dividend range for the stock as a guide in order to gauge how much extra cushion you have.
Stocks That Make Boring Products
For me the poster child for this scenario is Proctor & Gamble (PG). These stocks should produce a product that is needed whether the economy is in a recession or humming along beautifully.
In addition to a dividend cushion (if there is one for your boring product stock) you’ll also have the added cushion of necessity. Even in a bad economy people need soap and toilet paper.
I like to follow the same process I follow with my range bound stocks. Line up a stable of 5-10 boring product stocks so I always have one or two to choose from to sell puts on.
Finally, let’s discuss USO and why I like to sell puts on oil:
Oil, Specifically USO
It costs a certain amount of money to drill for oil. When the value of oil drops below this amount, then the producers turn off the wells, which creates less supply, and given the good old supply demand curve, the price either stabilizes or begins to rise.
If you accept that premise, then where is a good point to sell puts? You got it, when the price of oil is around that production price point.
In a good economy you may not reach that level, because demand is more in control of the price than supply. But, even so, you always know you have that cushion near production cost (ah my cushion theme arises again).
So, with that under our belts, take a look at USO over the past 5 years. Does it look familiar…range bound? Yep, in the low $30s that production cost kicked in and bounce after bounce occurred. And now, the…
Trading and investing is largely about recognizing and taking advantage of patterns. Shorter term patterns for trading and longer term for investing.
The patterns can be found on stock charts, in the business cycle, and in companies executing on a defined strategy.
When selling puts it is important to see, or at least have a sense of, the possibility that a pattern is changing. Selling puts near support is great as long as support holds, but a pattern change may tell you that support is no longer as reliable as it once was.
This possible pattern change is taking place in oil right now. Lowering the cost to get at huge reserves of oil in the U.S. has brought an increased supply onto the market. This increased supply, and the fact that it is in the U.S. where the world’s largest economy can control it, will very likely result in a pattern change in USO.
USO has already broken $30 support, and may (or may not) head lower. My point is that the pattern is not as reliable at this point as it has been in the past, and this makes for a riskier proposition in put selling.
You don’t have to figure out, or predict, the new pattern. There are plenty of opportunities in other boring, range bound stocks. But, you do need to recognize the possible pattern change and move on until the new pattern emerges.