Answering Questions about selling puts and revealing a strategy

An investor friend has asked me some questions about the selling of put options.  His questions are in bold italics.

When you sell puts, do you have to cover the dividend distribution for the buyer? No.  You don’t own the stock.  You have sold an obligation to buy the stock at the strike price –at a random buyer’s discretion–the contracts are fungible, so assignment is an entirely random process (especially early assignment, which is very rare).  The dividend belongs to those who have open contracts on the other end (they bought the put as an insurance and they are holding the underlying).  If I am assigned the stock before the ex-dividend date the dividend is mine.  If it is after, the dividend belongs to the buyer of the put.  Regular dividends are calculated into the price of the premium, according to the experts.  But extraordinary dividends are considered part of the strike price (i.e., a $3 dividend for Microsoft, would mean that on the day of expiry if Microsoft was $25 and the strike price was 29, the $3 extraordinary dividend would be added to the 25 and the contract would expire in the money.  If assigned, the buyer would relinquish 100 shares and $300.

I love your approach and I can probably do the same thing with Daylight energy (which is my boring PBN in a way)

For example:

DAY puts for April 11 @9.00, If I sell 1,000 @0.09 = $90

If the price expires, I get to keep the $90

If the price hits 9$ and the put gets exercised, then I am forced to buy 1,000 shares @ $9?

The commissions would kill you in such a transaction; I pay $1.25 per contract plus $9.99 per transaction.  = 12.50 plus 9.99= $22.49

I plug the numbers into a spread sheet that calculates commissions and the % gain over capital put at risk.  My goal is cash flow, to make pay payroll of my assistant and me.  So the risk capital is the full price of assignment, 100 x # of contracts x strike price +$43 (discount commission).  Thus the daylight spread would look like this:

Canadian Options Share price strike Premium days to exp contracts commission gain day 1 % gain annualized per day if assigned total net net share price if assigned
put apr day $10.38 9.00 0.09 72 10 22.49 $67.51 0.75% 3.78% $0.94 9,043.00 $8975.49 $8.98

The money here is just simply not good enough to bother with.   My hunch is that price is actually a consolation prize for those who have given up on the contract and want to move on and that a majority of these transactions would be closing transactions—though I’m not experienced enough to know—but I would never do such a transaction except to close open contracts (i.e., buy to close).  It is only 3.78% annualized gain on risk capital.  The capital I’m using to sell puts actually has to gain more than that or I’m not making very interesting money.  I am much happier with 20% annual gain, because it has to pay me something to set aside risk capital for 72 days.  The thing about puts is that you have no upside potential. The premium is all you get if the darn thing goes up.  So you have to make it worth your while if you are going to risk that kind of capital.  20% annualized gain make sense.  3.78% doesn’t.  I have to make the 20% because someday I’m going to bite the bullet and make good on every stinking put I have on the table—the $9 strike price may seem safe, but there are black swans, so I have to have the capital in reserve no matter how far out of the money the strike price happens to be.   If I make 20%, then my hope is that by the time the downturn happens, I’ve gained sufficient capital that I can easily absorbed the puts.

To get the 20% or more annualized gain, you have to do at-the-money puts—either with short or long time value.  The longer the safer (because the price of underlying and risk capital goes down, but more dangerous because a lot of stuff can happen in the meantime), because you are selling time.  But the shorter puts give the highest bang for the buck.  Consider the following example of the pre-spinoff shares of Petrobank with a two month expiry date (the last two months is when the time value collapses at the fastest rate):

Canadian Options market strike Premium days to exp contracts commission gain day 1 % annualized per day if assigned total net net share price if assigned
put Jan Pbg $40.63 42.00 3.00 61 1 11.24 $288.76 7% 42% $4.73 4243 3954.24 39.54

It expired post-spinoff out of the money, and I keep the premium of 288.76.  This was an annualized gain of 42% of capital at risk (but I used leverage, so I didn’t actually have to put anything up).  If assigned, I would have paid $39.54 net which was a savings from the market price of $40.63.  The downside is that the closing price of pbg1 = pbg*1, +pmg*.615 = $46.99.  If I bought the pre-spinoff pbg, I would have made $46.99-40.63 = $6.36*100=$ 636 – 4% interest on (40.63*100+9.99).  So you see, I have lost the upside potential in the same way I would lose it if I bought pbg at 40.63 sold pbg at 43.59 and watched it go up to $47.  But in the put scenario, the money is transferred into my account on the day after my transaction and I can use it to make payroll or to buy another investment.  This was an in the money put — I was bullish on PBG and happy to take the underlying if it expired still in the money (for a net price of $39.54—the “if assigned” column minus “gain day 1” (total premium minus commission).

I add up the “if assigned” column on all open contracts, and that is added to the total leverage when I calculate debt to equity ratios for the holding company.  The idea is to keep track of the total leverage including puts if assigned and to keep that leverage at a manageable level.

If the price expires, I get to keep the $90?

You receive the money the day after the contract is opened.  It is yours to keep.

If the price hits 9$ and the put gets exercised, then I am forced to buy 1,000 shares @ $9?

You must buy it upon expiry at $9 per share plus the commission, if the stock is below $9–but if it is in the money just a few cents, indeed less than the commission, I doubt that most buyers of puts would want to exercise, since it will cost them more than selling on the open market at the discounted trade rate–at my broker, exercise or assignment is $43 commission, while discount trade commission is 9.99, why exercise in that case if its only a few pennies in the money?  The assignment/exercise commission rate is advertised by your brokerage.  The Discount rate for which I qualify at TD Waterhouse is $43.  It may be a lot higher for you at your brokerage.  So the cost of assignment is $9043 (see if assigned column).

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