4 Basic Rules For Selling Puts

My 4 Basic Rules For Selling Puts (Naked Or Cash Secured)

Rule #2 - Always Remember Rule #1

Rule #2 is simple and important -  never forget rule #1

Rule #1 is what gives me confidence to make enormous profits while others flee the stock in a selloff or market collapse. Remember that selling puts is a strategy of small profits that compound into big profits, but when I always stay with Rule #1, I then have lots of confidence in my stocks.

Therefore, when a collapse occurs or a downtrend starts, I know that opportunity is coming. Other investors are fleeing their stocks while I am benefiting from the higher put premiums as volatility is rising. To understand volatility you might want to consider reading Understanding The VIX. It is volatility that is the put sellers greatest friend. When panic ensues volatility climbs and put premiums rise dramatically. Suddenly monthly premiums that might have paid me 1 percent are 4% in a correction or even 8% in a crash.

It is Rule #2 then that creates enormous profit potential. These profit potentials are unmatched by any other type of investment and these profit potentials can appear every so many years. Therefore while I am content aiming for 12% a year in my option selling, I know that by always remembering with Rule #1, I can make enormous profits while other investors flee in horror from the collapsing stocks. It is not uncommon for my portfolios to earn 60% or better in bear markets. In the last 10 years I have been in two bear markets and lots of market and stock corrections. Earnings of 60% twice in those periods of time have meant I have more than doubled my entire portfolio.

This is why I have always stayed clear of stocks such as Crocs which I discussed in Rule #1 of this article. While it is true that there is the potential to earn enormous profits by buying such stocks as Crocs at the low, it is also equally true that not only cannot I not guess where the bottom is in a stock such as Crocs, but also many such companies end up in disaster and can wipe out a portfolio that took years to make.

Instead I prefer my strategy of picking companies that are well diversified, larger than many banks and have enormous futures ahead of them. Here are a few examples:

Below is a 2001 stock chart from one of my favorite stocks, Intel Corporation (INTC). Of particular note is the 2001 price points which are not very far off from where Intel trades presently. I had been selling puts in Intel throughout much of 2001. Then in August I had sold 10 Oct $22 put contracts for .33 cents when the market changed direction.

When the market crashed that September, I immediately put capital to work in Intel. On September 19 2001 I sold 10 October $22 puts for $1.45.  That is 6.5% when weeks earlier I had sold the same strike for just .33 cents.

The following day as panic continued, I sold 10 puts October $22 at $1.95. That is 8.8%. The next day the market really tumbled and Intel fell to $18.96 and I sold 10 October $20 puts for a terrific $1.58 or 7.9%. I then bought 1000 shares of Intel at $19.10.

Total income over the 3 days was - $4980.00. Total Capital committed to puts over the 3 days was $64,000.00 - Total return = 7.7%

By October 11 the stock closed at $24.51 and I sold covered calls on my shares. I sold the November $22.00 for $2.95.

The puts all expired in October including the puts I had sold in August for just .33 cents and my shares were exercised in November.

Total return = Naked Puts Sold During Crash - $4980.00
                    Stock Covered Calls -                 $2950.00
                    Stock Exercised -                      $2900.00
                    Total Earnings -                       $10,830.00
                    Total Of Capital Used -             $83,100.00
                    Total Return From Crash = 13%
 

Below is the Volatility Index Chart for the September 2001 period. With the volatility up to 49.00 the put premiums in particularly escalated throughout the day. This is the type of volatility I am seeking as a put seller. However in order to benefit from it, I have to be comfortable with the stocks I am selling puts against. That's why Rule #2 is so important.

Then just another year later, there was another crash, which ended up bigger than 2001. Below are all my trades during the 2002 crash period in Intel Corporation.

Chart doesn't show October $14 puts expired.
Total return for this period was Puts Sold and Calls Sold - $8060.00
Shares Exercised Nov $16 strike - profit -                         $2200.00
Maximum Capital Used to November Options Expiry - $61,600.00 - total profit $10,260.00 = 16.6%

Capital committed after November options expiry - $33,800.00

Here is the remainder of the trade:
Dec 20 2002 - options expiry - stock closed at $17.01 - stock was exercised - profit = $3200.00
Jan 16 2003 - options expiry - stock closed at $16.34 - My Jan $18 strike was not exercised.
I sold covered calls on these shares until I was finally exercised of them in June at $20.00.
Below is the VIX chart for the same period. You can see the heightened volatility  through the entire period. This is what worries investors. The volatility rising creates whipsawing in the markets. For many investors it is a scary time. But for option selling it can be a terrific opportunity. 

I am showing these trades to demonstrate how opportunity presents itself, but without Rule #1, then Rule #2 does not work and I cannot then take advantage of stock collapses and recoveries.

The Intel trade is also interesting as you can see how Intel is pretty well trading in the same range today. So while analysts comment about how little reward there has been for investors in stocks like Intel, it is because analysts and investors do not see the strategies that are available to take advantage of the volatility.

Just two more charts to show. Below is Intel for the past 10 years. Every year there has been volatility which has created enormous profit opportunities. Overall the stock is really not going anywhere. However the key to Intel is that it is a giant of a company with huge profits but it is often driven by investor fear. Investors are always trying to second guess the technology market and worry that PC sales may be slipping or Intel may not get into the handheld market or Intel chips may not be used by most phones, etc, etc. There are just so many worries with a stock like Intel. This is why Intel is a great play on volatility. However it is also important to remember the peak prices and the valleys. It is important to try not to sell puts near the top of the ongoing range in Intel, but to sell the lower strikes. If the stock moves higher then I sell further out and still stay with lower strikes.

Finally to close Rule #2, is this chart from the collapse of 2008. This is what opportunity looks like in a large cap, quality company. This is Bank of Montreal stock (BMO) on the Toronto Stock Exchange (TSX). In the crash of 2008, this Canadian Bank eventually fell along with most banks around the world. The difference though is Bank Of Montreal paid a dividend of $2.80 which although analysts claimed it would be cut, did not cut its dividend as did none of the Canadian Banks. Today Bank Of Montreal stock has recovered to the $60.00 range and I am earning 10% annual dividend payments. This would not have been possible without a market crash and without Rule #2.

Summary Rule #2

Without Rule #2 I cannot have confidence in my stock choices and my trades. Therefore I could not take advantage of volatility and as such it would be more difficult to earn large returns during periods of extreme volatility. When stocks have a "fire sale" I want to be able to take advantage of those low prices, but without Rule #2, it is impossible.

Article Index
Go To Rule #1
Go To Rule #2
Go To Rule #3
Go To Rule #4

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