PUT options are an excellent tool to leverage the realized return for a value investment based portfolio of securities. In general, options are very risky financial derivatives and are not recommended for unsophisticated investors. In laymen terms, options are classed as mildly speculative instruments in the world of investing. The key to proper use is to eliminate the risk aspect by only utilizing PUTs in a very restrictive set of circumstances. When properly applying restrictions, PUT options can add between four and ten percent of a value investment fund’s annual realized earnings. This marginal improvement is how a value investment fund outperforms even the best performing index based funds.
PUTS are an option contract, a form of insurance, whereby the seller agrees to purchase stock if the market price for that stock falls to certain price, known as the strike price.
Yesterday, May 3rd, 2022, the Value Investment Fund sold 246.9135 PUTs on JPMorgan Chase & Co. with a strike price of $80 per share. These PUTs expire on June 16, 2023 (13 months). The Fund sold the PUTs for $2.76 each and netted $1.76 each after fees. Total realized income was $434.57 (246.9135 * $1.76/ea).
Today, the Value Investment Fund sold an options contract (PUTS) for 116.9591 shares of Huntington Ingalls Industries at $5.90 per share netting $4.90 per share. The strike price is $170 per share which is 4% lower than the buy price as set for this particular member of the Military Contractors Pool. The intrinsic value of Huntington Ingalls Industries is currently calculated at $185 per share. Current market price today, January 7, 2022, is $192 per share.
Union Pacific is a high quality stock. Over the last twenty years, this company has never failed to earn a profit. During this time period, there have been two recessions. The simple fact is that Union Pacific is a solid investment. The company has paid a dividend for the last thirty years. Its current yield at $210 per share is 1.83%.
Union Pacific’s intrinsic value is estimated at $185 per share. Thus, any opportunity to own Union Pacific for less than $185 per share is considered an excellent buy.
From the Lessons Learned article for the Value Investment Fund’s 2020 performance, one of the additional tools to leverage higher the Fund’s annual return is to sell PUTs. A PUT is an option for the holder of the PUT to sell an asset, in this case stock, for a preset price referred to as ‘Strike Price’. The seller of the PUT is basically selling an insurance policy that if the market price drops to the strike price, the seller of the PUT is willing to buy the stock at that price. PUTs are a viable alternative to owning stock at less than intrinsic value.
With options, an owner of stock fears a sudden steep drop in price and thus they may purchase an option called ‘PUTs’ to force someone to buy the stock at a preset price. The key for the owner of a PUT is to set a floor price for their existing stock position. A seller of a PUT desires to own the stock at a certain price if it can get there.
When selling PUTs in the market, value investors cover their position by purchasing a similar position in an existing low price to book stock. In effect, the position acts as a bank account in case the PUTs are activated, thus the existing stock is sold and the proceeds are used to cover the PUTs financial obligation. This also helps to diversify a value investor’s portfolio.
There is some minor risk involved, i.e. the stock purchase acting as the bank for the PUTs could go lower. However, value investors do their homework and limit downward pressure by purchasing extremely high quality stock backed by intrinsic value. This is covered in another article in the Value Investing Lessons series available to members of the Value Investment Club.
Do you want to learn how to get returns like this?
Then learn about Value Investing, a systematic conservative approach to earning excellent returns over time. Value investing in the simplest of terms means to buy low and sell high. Value investing is defined as a systematic process of buying high quality stock at an undervalued market price quantified by intrinsic value and justified via financial analysis; then selling the stock in a timely manner upon market price recovery.
There are four key principles used with value investing. Each is required. They are:
– Risk Reduction – Buy only high quality stocks;
– Intrinsic Value – The underlying assets and operations are of good quality and performance;
– Financial Analysis – Use core financial information, business ratios and key performance indicators to create a high level of confidence that recovery is just a matter of time;
– Patience – Allow time to work for the investor.
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Today, I sold 59 PUT options for Union Pacific with a strike price of $170.00 with a final date of February 19, 2021. PUTs are simply selling insurance that if the stock price drops to $170 per share, the Value Investment Fund will have to buy them from the owner of the puts. Today, the PUT for $170 is selling for $6.60 each. See the BID column and the highlighted reference point. Thus, if exercised, the Fund will have to put up $10,090 including transaction fees.