Part five of my series on portfolio construction is all about options.
music selection: “Say Hello 2 Heaven” — Temple Of The Dog
Most of my portfolio is static and doesn’t move from month to month or even year to year. But I do keep about a third of my holdings in cash to secure written puts. The reason is simple. The yields are higher and safer than I can get with high yield, DGI, fixed income, or insurance. Note that I recommend against writing puts on margin. Yes, the returns are 5 times larger but so is the risk. Don’t be a dumbo T. Rex.
The first consideration is always safety. See, sooner or later you will get assigned. You don’t want to get assigned shares of Crappy McCrap Co (CRAP). But if you get assigned to Blue Chip Von Megacap (BLUE), you can sleep well at night knowing that not only is your investment not going to zero, it will likely grow and outperform the market as a whole.
I like insurance companies, Big Cheap Tech, and the Dividend Aristocrats for most of my option plays. I spent time
enslaved working for Oilfield Services so I sometimes dabble in oil industry stocks as my underlying for writing puts. One I like now is Hi-Crush LP (HCLP). It is only partly in oilfield service and has a stable and profitable business backing it up when frack sand sales are slow. And the yield is tasty.
The last thing you consider when choosing a company to write puts on is yield. You should never, never, never, never, (NEVER!) accept less than 12% annualized yield on your written puts. Just wait a few days and a fatter pitch will be by. Days like today are ‘good’. Greek panic combined with Chinese panic is pushing volatility high. This leads to plump put premiums. If the morning’s cover of the New York Times reads “President Declares Most Boring Day Ever” you want to wait until tomorrow to write your puts. Your counter-party’s fear is a delicious treat (tastes like chicken!)
You want to target 6 to 8 weeks out for your expiry in most cases. Reason is, the decay of time value in your premium is not linear and moves quickest around a 7 week sweet spot. Thus, you will usually find the highest annualized yields for a given strike 6-8 weeks out on expiry. It doesn’t hurt to check further out but 90% of the time you will find the short time frame is best.
Sometimes, a raptor gets assigned. Turn that frown upside down and celebrate. If you followed instructions from earlier, you refused to write puts on anything you wouldn’t be happy to own at the strike price: you just got your wish. Usually, it is a good idea to write covered calls about 10% out of the money. Again about 6 to 8 weeks out for expiry is ideal. Aim for about 2% annualized bonus return when doing this. If you are with a big blue chip that is growing 5% a year and yielding 2% more, you are looking at a 9% blended return if you continue to hold (e.g. your out of the money calls expire worthless). If you get called away, you just picked up a bonus 10% yield for 6 to 8 weeks of waiting, a gonzo annualized return AND you got to keep your call premium. When a stock is fully valued based on P/E, Price to FCF, etc., it is time to write your covered calls at the money. Once again, you want 6 to 8 weeks out and you want to accept no less than 12% annualized for an at the money covered call. Else, go up a strike to give up some immediate yield in exchange for the potential to capture some upside appreciation.
In five parts, that is how I do it. The blended result is a return a little over 8% against a withdrawal rate of 6%. So my stockpile is continue to grow by about four months expenses per year and outpace inflation. What I like best is ten years from now, my withdrawal rate will be even lower and I will have gained security all while shunning Big Corporate Drudgery. Life is good.
Devour your prey raptors!