1. Prepared by
Thomas A. McDevitt
Chartered Financial Analyst
Certified Financial Planner
May 2011
Selling Puts:Getting Paid While You Wait

2. Investor Conundrum-Part I
Many investors feel as though they missed out on the rebound in equity prices from 2009 to the present.
3. S&P 500 Up 101.60% Off Of March 9th, 2009 Low
4. Only Fools Rush In
5. Danger Ahead?
Presently a high level of bullishness amongst investment advisors. A historically low percentage of investment advisors expect the market to go down. This should be viewed as a negative (the masses are asses).
The CBOE Volatility Index (VIX) is at pre-crisis lows, indicating investor complacency.
Stocks arent cheap anymore, as measured by Tobins Q.
6. Tobins Q
7. Investor Conundrum-Part II
As investors wait on the sidelines for a better entry point into the stock market, they are earning a negative real rate of return (interest rate earned less inflation).
Investors in cash positions are losing wealth with each passing day.
8. Inflation:Somewhere Between 2.00% and 11.00%
9. 1.71% on a 5 Year Treasury
10. Cash is Trash
11. Selling Puts
One way to enhance cash yields and control portfolio risk is to sell puts against equity investments.
This strategy is appropriate for opportunistic investors with large portfolio cash positions who would shift from cash to stocks at lower stock market levels.
As you will see, the strategy can be adjusted to accommodate all types of investor objectives from the conservative to the highly aggressive.
12. Selling Puts
When an investor sells a put without ownership of the underlying instrument, he or she is agreeing to purchase the instrument at some specified price on some specified date.
13. Selling Puts
Example
Jane likes ABC stock, but doesnt want to pay current market prices.The stock is currently $100 per share.She would be comfortable buying ABC if it hit $75 per share.
14. Selling Puts
Jane can call her broker and place a good-until-cancel order to buy ABC at $75 per share.If the stock never trades to that level, Jane will not be executed.
OR
15. Selling Puts
Jane can call her broker and agree to buy the stock at $75 per share in January 2012.She does so by selling a January 2012 Put on ABC with a strike price $75.The January 75 Put on ABC is trading at $2.
Lets assume that Jane would want to purchase 1,000 shares of ABC if it hit $75 per share.
16. Selling Puts
In return for selling the put, Jane will receive $2,000 today ($2 option premium xs 1,000 shares).The money gets deposited into her brokerage account.This is her money to keep.
Janes obligation is to purchase shares of ABC in January 2012 at $75.
17. Selling Puts
If ABC is above $75 per share on expiration in January 2012, Jane will not buy the stock.The put simply goes away.
If the stock is $75 per share or less on expiration in January 2012, Jane will be required to buy the stock.1,000 shares xs $75 = $75,000.
18. Selling Puts
Note that Janes cost basis in ABC will be lowered by the amount of option premium collected.In this example, if Jane actually ends-up purchasing the stock, her cost basis will be $73 per share.
$73 Cost basis =
$75 purchase price - $2 option premium received
19. Selling Puts
Since were interested in mitigating risk, lets expand the example.Lets walk through an exercise in which we sell puts against a broad basket of stocks instead of a single, standalone company.
20. Diamonds
Diamonds (DIA, NYSE) is an exchange traded fund (ETF) that is designed to track the performance of the Dow Jones Industrial Average.
On May 27th, 2011, the Dow Jones Industrial Average closed at 12,441.Diamonds closed at 124.28.Simply move the decimal point over two places to the left on the Dow Jones to come up with approximate value of Diamonds (note, small differences will exist).
21. Diamonds--Holdings
22. Diamonds
Lets assume that Jane would enter the stock market if the Dow Jones Industrial Average, which is currently 12,441, falls to 11,500.
What can she do other than keeping her funds in a low interest bearing instrument?
23. Diamonds
A Dow Jones price of 11,500 is comparable to a Diamonds price of $115 (Diamonds or DIA is presently $124).
Jane can sell a January 2012 Diamond (DIA) put with a strike price of $115.The put premium on this contract is presently $4.15.
24. Diamonds
Lets assume Jane has $1,000,000 to invest in equities.How many contacts should she sell?
$1,000,000 $115 = 8,695
In return, Jane will receive $36,086
- 8,695 options xs 4.15 option price
This is Janes money to keep.
25. Diamonds
Janes obligation is to buy the Dow at 11,500i.e., DIA equivalent of $115if in fact the Dow is at or below this level in January 2012.
If the Dow is > 11,500 in January, the option will expire.
26. Diamonds
Note that Janes cost basis in the Diamonds will be the purchase price of $115 less the option premium received of $4.15 or $110.85.This is comparable to buying the Dow at 11,085, which is approximately11 % below current market prices.
27. Diamonds
Note that selling puts against the Diamonds has the effect of buying on weakness, which is a concept we all learned in kindergarten (buy low, sell high)!
28. Diamonds
No brokerage firm will permit an investor to sell puts without putting up some cash.
To simplify the example, lets just assume that Jane puts up her entire potential commitment of $1,000,000 when she opens a brokerage account;she places the funds in an 8-month CD yielding .70%.
29. Diamonds
Ending Value of Account if Dow > 11,500 in January 2012
Beginning Value:$1,000,000
Put Premium Collected:$36,086
Ending Value of CD:$1, 004,666
Ending Value of Account:$1,040,752
Holding Period Return:4.08%or 6.12% annualized
30. Pulling It All Together
Smart, logical, and hesitant investors face a conundrum.Stocks have risen sharply off of their March 2009 lows AND interest rates remain at historic lows.
Selling puts against the Dow Jones Industrial Average is a disciplined way to enhance cash yields while waiting to invest money in the stock market at substantially lower levels.
31. Are There Risks?
OF COURSE!
In the above example, the Dow Jones Industrial Average could be below 11,500 in January 2012. When Jane takes possession of the Dow (DIA) at $115 in January 2012, she would have an unrealized loss equal to:
Strike Price Option Received Prevailing Dow Prices
But remember, the cost basis is reduced by the amount of premium collected.So Jane would be most interested in seeing the Dow close above 11,085, as previously illustrated.
32. Are There Risks
And also remember that the investor can control where he or she wants to enter the market.The investor controls the degree of risk to be assumed!More conservative investors would select a lower put strike price (say Dow Jones 10,000).More aggressive investors would select a higher put strike price (say Dow Jones 12,000).
33. Are There Risks?
And, also remember, that a 100% cash position is actually destroying wealth!
And, selling puts against the Dow with strike prices at substantially lower levels is actually more conservative than being 100% long at current market prices!
34. Selling Cash Secured Puts
Increases yields on cash only instruments (CDs, Treasurys, Money Markets, etc.)
Gives investors a disciplined way of buying low
Has lower risk than an all-equity portfolio with exposure to prevailing market prices
35. Call Tom McDevitt Today at 215-990-0781 to Schedule an Appointment!