February 11, 2008

Using puts to reduce cost basis

A thought experiment -
Lets assume you find a stock which is undervalued and it is liquid (otherwise you may not get options on it). You buy the stock and would continue to buy if the price were to drop further (the critical point). In addition you sell puts for strike price say, 20% below the current price.

If the price does not drop, you keep the premium and reduce your cost basis. If the price drops by more than 20%, the put gets exercised and you buy the stock (which you any way planned to do so).

The key objections to this strategy could be

· Does not work with illiquid, lesser known stocks which are more likely to be undervalued
· if the price drops more than the strike price, say 30% then I am losing out on the additional 10% cost of the stock . In worst case scenario if I have mis-analysed the stock I could be in a lot of trouble as I may end up incurring huge losses in that scenario.
· Someone has to be ready to buy these puts (puts should be saleable)
· Stock has to be volatile enough to make the puts attractive and worth the effort
· Contract size – Does the contract size fit with the investment plan. May not work out for an investment plan of a few hundred shares in some cases

A few other cases

· Buying undervalued stock and sell calls at 60-70% above strike price
· Buying long term options on a stock (LEAPS in the US ..not sure if available in India)

I have analysed a few cases such as the above in the past. However once I have looked at the possible scenarios which can play out, done an
expected value analysis and compared it with the cost, most of the cases turn out to be low in returns and moderate to high in risk.

Please feel free to comment on the above strategy or any better ones you may have tried.


VISHNU said...

Hi Rohit,

I still feel Indian equities are over valued ,Hence I am more looking into Risk Arbitrage opportunities (Anyway I am not even a novice here)

I was reading WarrenBuffets Annual Meeting Notes and seen the valution method given by Warren on Petro China and it was eye opening. (Infact It was looking mouthwatering at the simple valuation methods)

If you are looing for an valuation with stable company like Petro China , I couldn't find any more in Indian Markets atleast


We bought Petro-China a few years ago after I read the company’s annual report. It’s the first Chinese stock we’ve owned, and the last, so far. The company produces 3% of the world’s oil, which is a lot of oil. It is 80% the size of ExxonMobil. Last year Petro-China earned $12 billion. Just 5 companies on the Fortune 500 made that much last year. When we bought the company, it had a market cap of $35 billion, so we ended up paying 3 times what the company earned last year. Petro-China doesn’t have a lot of leverage. It will pay out 45% of what it earns, so based on what we paid for the stock, we’re getting a 15% cash yield on our investment. The Chinese government owns 90% of the stock and we own 1%, so I like to joke that between the two of us, we control the company. Unfortunately, we had to disclose when we owned 10% of the non-government class of shares. We would have bought more, but the share price rose. Management does a good job running the company. Petro-China has 500,000 employees.

Rohit Chauhan said...

Hi vishnu
ideas like petrochina do come up...but only rarely. i doubt if we can find one in the large cap space in the current market. i would think they type of opportunities are more likely during a bear market


Gaurav said...

It is a great strategy particularly when current volatility > historical volatility. If current volatility is lower than historical and one is bullish, it is better to buy call options.

Otherwise what might happen is that if volatility increases suddently and the price of option jumps up suddenly, one will get margin calls and be forced to close out the position if leverage is high.

Also, another problem is if one really likes the stock and the stock goes up, the profit is limited to the premium collected. So suppose stock is at 100 and I think it can go up to 300, potential profit is 200. If I were to write put options, I will collect - say Rs 10 (as I dont want my initial exposure > 100 in case the put options really get exercised).

This is one of the best ways to buy stocks which have liquidity in options market.

Rohit Chauhan said...

Hi gaurav
i would prefer buying put than selling naked puts. that could expose you badly and i think for an individual it is a risky strategy. it is like taking in a small insurance premium and paying out when there is a catastrophe ..

i am sure if i understand your comment on losing on upside of a stock. do you mean to say that if you write puts, you lose on the upside ?

Deepak Shenoy said...

Rohit, the strategy you mentioned in the post involves Selling Puts, not buying them. Selling puts is bullish, buying puts is bearish.

While selling puts has unlimited liability you can sell the future to cover a loss if the stock looks like it's going down.

To your question: Long term options don't exist in India. You have 1, 2 and 3 months forward options and even in those only the 1st month are liquid. Not all stocks have F&O on them and not all f&o stocks have liquid options.

Eg: http://www.moneyoga.com/option.aspx?s=INFOSYSTCH

At this point, Infy puts are barely traded!

Nifty though is heavily traded on options so if you wanted to buy the broad Nifty you could write puts. Premiums are good,

In writing puts you will get a premium. Eg. Say you are bullish on
Nifty and you write a 5000 put at Rs. 85 today. Expiry is next thursday. Let's say Nifty goes up by 200 points till then. The Rs. 85 premium you got is all you get. the extra 115 points you cannot participate in. (The only thing to do is to close the put by selling it in the market and then buying a Nifty future or such)

Insurance is a great thing, Rohit - Buffet's bread and butter. When premiums become astoundingly high, you can walk in and steal the show.

Rohit Chauhan said...

Hi deepak

my approach to puts is more to hedge my portfolio and less to take directional bets. so i may be bullish on the stock and still buy puts to hedge against a bearish outcome

i am not comfortable with writing puts. As you said - it is equivalent to writing insurance and it may be profitable for a company which can spread the risk. However i not sure if that is a good strategy for a retail investor. there are several cases such as Victor Niederhoffer (see wikipedia for his story) , a famous hedge manager who blew up for writing options.

you are exposed to black swan or sudden events when you write puts.

i agree you can cover it by selling the future. but is it profitable after considering the bid ask spreads and commision ..personally i have not analysed and dont know ? do you have some stats on that ?