Adam Warner

Don't Miss Out on Put Selling Opportunities

by Adam Warner    12/17/09

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A Goldman Sachs (GS) study found that selling puts is an attractive way to buy stock of, or increase exposure to, companies with large stock buyback programs.

According to an article in Barron's:

"They found buyback programs potentially reduce the implied volatility of put options. And that may have broader implications for options volatility, which is the most important part of options prices.

"While this point was not mentioned in the report, the findings suggest buyback programs might even lower overall options volatility. Why? Puts, which increase in value when stock prices decline, drive overall options volatility."

The theory is not exactly radical. If the company puts a floor in on their stock price via constantly bidding, investors will have little fear of selling out-of-the-money (OTM) puts. And OTM put demand tends to drive the overall volatility of a stock.

So, if you expect a buyback, you certainly can't argue with selling some puts on it.

So what does Goldman look for in a good candidate for a put sale on a stock-buyback program?

They have a list of characteristics:

1. Sell puts that expire in six months and that are 5% out-of-the-money. This means the puts increase in value if the stock price declines by 5%. Of course, investors can pick any strike price that they wish, but that changes the probabilities of simply collecting money for selling puts and buying stock.

2. Six-month implied volatility is higher than three- and six-month realized volatility, indicating that the options market thinks the stock has a greater chance of moving in the future than in the past.

3. Put volatility is elevated, as evidenced by "skew" -- the difference between out-of-the-money put and call implied volatility -- being higher than the average Standard & Poor's 500 stock.

4. Buy- or Neutral-rated stocks that have not yet exceeded Goldman's price targets.

[Editor's note: List taken from Barron's.]

How Does Goldman's Criteria Measure Up?

OK, let's take a closer look at these.

The 5% OTM condition sounds very sensible, but the six-month duration may not work for many. Options do not decay much on a day-to-day basis until you start getting close to expiration. And then, of course, they go "exponential."

So, the question isn't so much whether you want to hold the position for six months, it's whether the best plan is to just sell the puts once and forget about them, or sell puts each cycle and then roll out to the next cycle each expiration. Or what about something in the middle like selling two months out and rolling then?

There's no single correct answer, but I'd suggest one advantage of going shorter and rolling is that you can take another look. Perhaps the puts have worked very well and you can roll to a higher strike? Or, conversely, if they have not worked out, you close them or roll lower.

As for realized volatility (aka historical volatility), whether you're selling one-month or six-month options, you should only look at shorter-term historical volatility (HV). Options price off the feel of the market in the here and now, so if you go too far back with HV, you'll include data that truly has no relevance.

Consider if you looked at 180-day HV back in July. It still included data from the fall swoon, so it read over 50. But options going forward traded at about a 28 volatility.

Sounds like a steal, right? Wrong. They have drifted down since then and now carry a 23 volatility.

In other words, I wouldn't make 180-day implied volatility (IV) being higher than 180-day HV or 90-day HV a pre-condition for selling the puts.

A better way is to calculate the average 20-day HV reading over the past few months. In the SPDR S&P 500 (SPY) that number is about 15-16 versus the 23 volatility you can get selling six-month options.

As for skew? Well, that always helps. But a buyback in progress may have already suppressed the puts. And they still may be a good sale.

All in all, the concept of selling puts on buyback candidates makes sense, just be careful of screening out too many good candidates by strictly adhering to the rules mentioned above.

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