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Protecting Your Portfolio When Selling Put Options

On Monday, I explained how it was possible to make $1000 per month selling puts but mentioned that there could be a big risk involved should the stock drop precipitously such as might happen following a missed earnings report.  That would be absolutely tragic and could negate a year’s worth of profits or more.  So how might we protect a portfolio when selling put options?  Let’s go back to our Pepsi example to find out.

Sell Some Puts and Buy Others

Using numbers from yesterday’s close, I see that Pepsi stock ended at $65.93 which is up from a few days ago.  That means our April $65 put options have decreased in value.  In order to make a grand per month, I will be using the May option expiration and sell 29 contracts of the May $65 put options for $0.87 per share or $2,523.  (Remember that each option contract is for 100 shares of stock.)

As mentioned, a collapse of the stock to $50 would be problematic since it would force us to buy the stock at $65 even though it is only worth $50 per share and would cause us to realize a loss of over $43,000 on the stock position.  Losing $43,000 to make $2,500 is not my idea of a good time!  We need protection.

In order to do this, we will purchase some put options ourselves.  We can purchase the May $60 strike puts for $0.17 per share making our total cost for protection $493.  Now we have netted just over $2,000 in option premium and our risk has been reduced to $5 per share total or $14,500 for the full 2900 shares.  Much better than before.

Now if the stock drops to $50, we can exercise the puts and receive $60 per share or $174,000 in capital back.  But that is still a loss so why risk $14,500 to make $2,000?

Well, with that $174,000 we can go into the open market and purchase 3,480 shares of Pepsi stock.  Then we can collect dividends and sell calls with a $50 strike price starting the process over again.

Is the Stock Still in a Downtrend?

If you are concerned that the stock is still in a downtrend, then you can buy some protective puts.  For example, the June $45 strike price put options would cost less than the premium received for the June $50 strike calls so you would still collect a net premium.  If the stock starts to rise and you get called out, then you might have found the bottom and begin selling put options again.

If it consolidates between $45 and $50, then simply collect dividends and call premium while it does so.  And if it collapses even farther, then collect $45 per share when the put option exercises and expand your position.  The company would have to be in dire straights for this to happen since the yield would then have almost doubled and would be attractive to income investors.  (Sort of when I picked up Intel stock yielding more than 4%).

Retirement Plan

Ultimately, this is the type of strategy that I will have for my stock portion of my retirement assets.  I plan on selecting blue chip dividend stocks, selling calls to enhance the monthly returns and sell put options when the price gets too high and the yield too low.  Then I will plan on living off the dividends and premiums while keeping the principal intact.

Readers:  Any thoughts on the above?  Feel free to share in the comments.

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