Puts as a method of passive income generation
Puts as a method of getting long stock and passive income generation
I first identify a ticker that I think may be a great play to get long. This could be a new IPO that I missed a move on like the previously mentioned CMPS or a long standing name that I have conviction on like a MSFT and/or already own or as a proxy for the indices (TQQQ or UPRO for QQQ and SPY respectively).
I already kind of outlined the process for CMPS but will elaborate more here with say MSFT
1) I check that the options are liquid. Is this something with super wide bid/ask that I’m pushing the market around in? Am I going to get a decent fill? These are all important to me as I see little reason to pay the market maker more than I have to. I also want to be able to get out of the trade if I have to without getting taken behind the woodshed.
2) I look at the current Implied Volatility relative to past implied volatility. Am I selling puts when volatility is historically low? This may nix the trade or at least be a strike against, conversely is volatility really high in the name because market volatility is high or the stock recently sold off? This might make the trade more attractive.
3) I look for simple support/resistance on the chart and I use the volume profile to identify Value Areas Low and High as well as Point of Control.
4) I look to then see how far out in time I have to go to sell puts to garner enough of a credit that if I was put the stock, I’d be getting it somewhere near a support area and/or the Point of Control (where a majority of the volume went off and should serve as support).
5) Then I look at the strikes with the highest OI, these are where a lot of hedging should come in. Hopefully these line up or I choose a strike close to it (maybe just under).
6) Lastly I consider sizing. Is this something I already own and want to own more of or is it a new ticker. If it’s a new ticker and I am establishing a position I typically will sell something like half the desired position size that I would want to take on so I can re-evaluate if we get to the short strike. If it’s something I already own I just verify I am not getting too heavy in one name and size accordingly.
MSFT as an example
1) No worries here.
2) It’s a little low, coming off earnings but not bottom of the barrel low so a candidate.
3) It recently broke out at 130 and tested that level, maybe it’s looking to run?
4) The March 230 strike puts pay enough of a premium that I’d be put the shares in a decent support zone.
5) The 230 puts have 22K of open interest so that looks good.
6) I already own MSFT and I’ve been selling some calls in there so I’ll continue to do that, if some gets called away between now and then or the stocks if delivered would make my position too big I’d consider sell more aggressively the call side.
Managing the trade:
This is pretty straightforward if things go well, it requires no management, your puts expire worthless and you repeat the process (thus the passive income generation).
If the stock goes into a big sell off and it’s heading towards your put price, it’s useful to consider:
1) Did anything fundamental change with the stock that would make you not want to own it anymore at this level?
2) How close is the price to your short strike and how long until it expires? If you’re really close to expiry you may still be able to take this off for a winner in which case, see 1 above and decide if you should re-establish lower or wait and take delivery.
3) If you take delivery and for whatever reason you want out volatility is likely inflated due to the sell off and you have an opportunity to sell an in-the-money call (look for it’s extrinsic value or calculate it yourself) to be rid of the stock. If weeklies are available I’ll sell the following weekly in the money strike that Friday for the following week before I even take delivery.
4) If you REALLY don’t want to take delivery of this stock and are staring at a loser you either wipe the trade and chalk it up to a loss OR and this is a big OR you increase the size of your puts and roll out and down for a breakeven. I only do this if the stock is responding to general market malaise and the pullback wasn’t due to some fundamental change in the company. This is the benefit of using a smaller position to begin with. You’re not really violating your rules regarding sizing because you didn’t sell a put lot representing a total position size (did you?). If the stock is legit failing because the company is failing due to other reasons (hello coal mining names) its almost always prudent to just chalk it up to a loss at this point and not prolong the outcome and lose more money.
This strategy I find is best (and easiest employed) on stocks that you already have a position in that you are trading around like I do with AMZN. I own that stock from much, much, lower levels so I’m essentially trading around that position at this point. If I ever was put shares on my puts I’d immediately sell in-the-money calls to get out of those new shares using tax lot id or LIFO methodology to minimize the cap gains taxes and still have my core position so as to not get too big (it already is too big lol).
I like this strategy A LOT around things like TQQQ as I mentioned because the option premium is rich, but you have to be willing to take delivery of the stock as your short strikes WILL get tested (or buy to cover if you have nothing). Just this last week I was short the 92.50 puts in TQQQ and I already had enough shares so I rolled that 2 weeks out for another 1.00+ credit and took the whole thing off today for .28 or almost a $2/contract winner. If I hadn’t had shares I would have taken delivery because the stock literally closed right under my short strike. In something like TQQQ I don’t care much because I know the ETF is robust enough to withstand a large sell off (see March) and it represents the entire QQQ. With that being said, the margin requirements on it are high being triple leveraged and there are other, individual names with equal or better premium, I just think the risk is higher.
This is fantastic, GAN, thanks again for sharing it.
For reference (with respect to the MSFT example), this was originally posted on Feb. 3, 2021.