I often write about stocks that look good and conclude with, “Buy some shares, sell some puts or consider doing both.”
Many subscribers have asked for more information on the “nuts and bolts” of setting up portfolios in this way. Here’s an example of a multi-legged position in IT services provider Infosys (INFY) that I put money into last October 17.
The first thing that needed doing was identifying a promising underlying stock. INFY fit that bill. It was showing record sales, cash flow, earnings and dividends, yet it was offered at $14.56 per share, one of its most favorable valuations ever.
Its P/E was just 13.2x and its current yield was 2.95%. Those metrics compared with its 2010 – 2017 average multiple of 18.0x along with a typical yield of 1.74%. INFY looked great as a simple regression-to-the-mean valuation suggested a year-end 2018 target price north of $21.
On that October 2018 day 1,000 INFY shares cost $14,568 including commission. Three of the options positions were traded simultaneously with the purchase of the stock. The fourth, short 20 contracts of INFY’s Jan. 18, 2019, expiration date $17.50 puts, was added later with Infosys already at a higher price.
Let’s review what those short options positions represented at the time I sold them. Shorting 10 contracts of the Jan. 18, 2019 $15 puts, for $1.80 per share, meant standing ready to buy an additional 1,000 INFY shares at a net cost of $13.20 ($15 strike price minus the $1.80 option premium).
If I liked INFY at $14.56 I would have loved it even more at $13.20.
The longer-term Jan. 17, 2020 expiration date $15 puts brought in $2.55 per share in put premium. That dropped my “if exercised” commitment price to just $12.45. The more aggressive $20 strike price, 2020 expiration put fetched $4 per share. Break-even dipped to $16 but upside potential was greater than with the more conservative strike prices.
The extra contracts on the Jan. 2019 $17.50 puts only brought in $1.50 per share because Infosys had already moved up. Worst-case, forced purchase still became a very reasonable $16 even.
As of Aug. 8, 2018, with INFY @ $20.75, every one of these trades is in positive territory. The paper profit on my INFY shares was over $6,200. The mark-to-market gain on the four separate options sales totaled an additional $5,930 if I chose to “buy to close” right now.
Total paper profits on my INFY package of shares and short options was running north of $12,100 on Aug. 8, 2018.
I have no plans to close out the shares or options at the moment. I’d like to hold the stock past the one year mark to lock in the much lower long-term capital gains tax rate. All of the puts are now out-of-the-money and unusable unless INFY pulls back.
I’m still bullish on Infosys so there’s more to be gained from leaving things alone right now. If INFY remains above the various strike prices through their expiration dates the options will expire worthless. That is always the best-case scenario for option sellers.
Options sold, and never needing to be bought back, represent 100% profits on all premium received up front. How cool is that? You likely got paid hundreds, to thousands, of dollars and never actually had to buy anything to earn that money.
There is another great benefit to selling long-dated options. If you leave them alone until expiration in a future year they do not become taxable events until they are bought back or expire.
The cumulative $9,240 I collected when I sold those INFY puts has been in my brokerage account since the day after the trades were executed. Options have ‘next business day’ settlements.
If the 2020 puts expire in January of that year I won’t need to declare the profits on those trades until April 15th of 2021, when I file my 2020 tax year Schedule-D. That means the cash was in my hot little hands from October of 2017 through April of 2021 prior to incurring any tax liability.
In summary — buying stock is a bullish bet on shares trending higher over time. Ditto for shorting puts on the same underlying company. The two techniques are different, but each benefits from the same directional movement.
Either type trade can be profitable or unprofitable, depending on future share price action. Outright shareholders qualify for dividend payments over time while put option writers do not. Tax treatment, stocks versus short options, varies and is too complex to be covered in full right now.
Let me know (in the comment section) if you have any specific questions on that topic.
Buying attractive shares will always be the cornerstone of my portfolio strategies. Adding covered call writing and/or naked put writing is like the icing on a cake.
Who doesn’t enjoy a little icing now and then?