At T&T Capital Management (TTCM) our most important options strategy that we employ is the selling of cash-secured put options. Cash-secured means that we generally don’t employ using leverage in relation to options trading as it can cause problems, like any leveraged strategy can. Selling cash-secured puts allows the investor the opportunity to create a situation in which they will either earn an attractive income return on the maximum risk, or manufacture a cheaper entry-price into a stock that the investor wants to own anyways.
At TTCM, we are unique in that we combine this strategy with our core deep value investing philosophy. This means that we are only doing it with stocks that we believe are already undervalued and that we would be more than happy to own at cheaper prices. This is very different than other market participants that are constantly buying and selling options based on short-term expectations on mark to market pricing. That is much more akin to gambling or speculation, which do not meet our definition of an investment operation.
A logical question to be asked is, “if you like the stock enough to want own it, why not just buy the stock?” If we believe that the margin of safety and the return potential are so strong that we’d be silly to wait to own the stock, we will just buy it outright. Often we will both buy the stock and sell puts as well. This creates a situation where if the stock drops we are dollar-cost-averaging by getting exercised on the puts at cheaper prices, but will also benefit if the stock rises, both through the stock appreciating and our options expiring.
Selling cash-secured puts has a lower risk profile than just buying stocks outright, because the breakeven price is the strike price minus the premium that we collect from selling the option. In down markets or flat markets, this strategy should outperform unless the stock picking is very poor. In rising markets, this strategy may or may not underperform, depending on the severity of the increase in prices and the stock selection. If you believe stocks are likely to appreciate 30% a year, you wouldn’t use this strategy, but obviously that is not a realistic expectation. One thing that is important to note is that, the protection from selling the options only shows itself over time. For instance, when we saw the sharp decline in October the put prices went up causing short-term mark to market losses, but if prices would have remained where they were at the lows, but time had elapsed causing the options to expire, the full protection would show itself. Below I’ll give an example of how that works.
I’ve wrote many times about why we like AGO and feel that it is extremely undervalued, so that will make for a good example. http://seekingalpha.com/article/2690875-assured-guaranty-aggressive-stock-buyback-will-reward-long-term-investors
For the purpose of simplifying things I’m not going use precise prices, as this is just to show how things work:
Let’s say that on October 1st 2014 with the stock at $23, we sold a $22 AGO put expiring on January 2016 for $4.00 per contract. We believe the stock is very cheap and would be happy to own it at a cheaper price obviously. If the stock expires above $22 at expiration we will make $400 on a maximum risk of $1,800. This equates to a target profit percentage of 22% in about 15 months, which is quite attractive. If the stock expires below $22, we will end up owning 100 shares at a breakeven of $18.00 per share, which is a 21.7% discount to the price of the stock on the day of the trade This highlights the protection the strategy gives us.
Why this is all true in the long-term, let’s say that the market tanks like it did in the first half of October and AGO drops to $20. Now that $22.00 put that we sold for $4.00 might be going for $6.50, showing as a $250 loss at that time. This short-term mark to market loss is completely irrelevant to our strategy but it will reduce our account value in the short-term of course. If we could time things perfectly there would be no need to do anything other than buy or sell stock, but this strategy is built for the long-term, which is why we tell you to not focus too heavily on any one month, quarter or year. Over the course of time, there are huge protections in place. Now if the stock rallies, we might be able to buy back the option much cheaper locking in most of the profit in a much shorter time frame, bolstering annualized returns.
When you look at your TD Ameritrade account, the short option value number shows you what amount of premium would be added to your account assuming all options expire worthless. It also gives you a rough proxy for the level of protection you have from the premiums that we have collected. Often the short option value is 10-15% of your overall account value. We don’t expect all of that to expire worthless of course, but it is just a guide to take into consideration in addition to your account value. Because volatility has been low and markets are fairly expensive, most of our current options are now expiring in January 2016. We won’t see the full benefits of these actions until late next year, so patience will certainly be necessary. I’ve attached our publication on our 3 Pillars of Protection for more detail if you are interested. Thank you very much and if you have any questions please don’t hesitate to call me directly a 949-630-0263.
Get your copy of the publication Three Pillars of Protection.
TTCM – Three Pillars of Protection