Selling Puts as a Strategy

I wanted to use this article to review and discuss the end result of the blog I wrote last month on Talisman Energy (TSX:TLM). While there was substantial options activity last month on the stock, our focus was on one particularly large trade which consisted of the selling of 10,000 put contracts of the November $12.50 strike. Obviously the high activity was a result of the shift in investor sentiment after Carl Icahn took a 61 million share purchase (6%) into Talisman.

Now that the November options expiration has come and gone, let’s compare the outcome of the put sale vs. an investor outright buying the shares assuming the puts were cash covered and unleveraged.

Here are the specifics:

• 10,000 puts represent a 1,000,000 share play on the stock at the $12.50 strike.
• The option was transacted at $0.48.
• The stock was trading in the $12.70-$13.00 range at the time of the block trade.

The put selling investor had an obligation to buy Talisman shares at $12.50 over the 4+ weeks to the November 15th expiration. Having collected a $0.48 premium, the average cost base on an assignment would have been $12.02 which is $1.81 (13%) lower from its peak price of $13.83. The investor collected $480,000.00 cash flow (3.84%) for having taken the risk.

Now that we know that those puts profitably expired, we wanted to compare the outcome of the puts to the alternative of having bought the shares outright.

Share Investor:

• Hypothetically purchased 1,000,000 shares at $12.70 on October 9th 2013.
• Would have received a $0.071 dividend on November 14th.
• The stock is trading at $12.80 on the morning of November 18th.
• The share investor has $0.10 in unrealized gains and received $71,000 in realized dividends.
• The investor had all the immediate downside risk from the $12.70 price.

The Seller of the Put:

• Had an obligation to potentially have to buy 1,000,000 shares at $12.50 until November 15th.
• Originally received $0.48 premium or $480,000 for undertaking the obligation to buy.
• The stock closed above the $12.50 strike and the puts profitably expired realizing the $480,000 profit.
• Because the premium was received immediately, the investor only had downside risk below the average cost base of $12.02 or $0.68 (5.35%) less than the share investor.

When reviewing the different outcome possibilities, the only scenario in which the share buyer had any benefit was if the stock had a material advance higher above $13.18. Under the scenarios where the stock stayed the same, (like it did), the put seller came out ahead by over $400,000 after accounting for the dividend. At the same time, if the stock was to have unexpectedly dropped, the put seller would have bought the shares over 5% cheaper than the share buyer.

So when comparing the two approaches, the put seller clearly has an advantage of creating consistency and less volatility, while the stock buyer has the opportunity for extraordinary gains but is far more vulnerable to immediate downside risk and short term volatility.