Steve:

In past articles you've suggested selling puts to get long a stock. I understand the concept that this buys the stock at a discount, but I'm not figuring out the margin requirements and what is a good way to calculate the return. Keep up the good work.

Thanks,

-- J

Let's start with a quick definition just to make sure we're all on the same page: The owner of a put option has the right, but not the obligation, to sell stock at the strike price. Selling that put option is a promise to buy stock -- through the assignment process -- at the designated stock price.

Selling puts is a popular method of accumulating stock because it establishes an effective purchase price that's typically below the current market price (the strike price minus the option premium collected) while also offering a way to profit if the underlying price rises or even declines slightly.

For example, assume that XYZ Corp. is trading at $47, and you could sell the August $45 put for $1.50 a contract. The break-even, or effective, purchase price is $43.50, which is 7.4% below the $47 share price. If XYZ shares are above $45 on the expiration day you can reap a maximum profit of $1.50 a contract. Note that this maximum profit is achieved even if XYZ declines by 4.2% to $45, or if the shares double to $94. In the latter case, you'll have left a lot of money on the table. Therefore, selling puts might not be the best strategy for stocks that have the potential to shoot higher in a short time frame.

But let's assume XYZ shares remain at $47 and the August put expires worthless. What did this trade return? An often-used calculation is dividing the premium collected by the share price -- in this case that would produce a yield of 3.1% over the seven weeks, or about 23% on an annualized basis.

However, there are two problems with this method: 1) It's not based on your true cost or capital requirements; and 2) the annualized return is based on the assumption that this position is repeatable another seven times over the next 52 weeks. (I plead guilty, however, of using this on occasion, especially when trying to extrapolate an expected returns strategy such as an ongoing covered call program.)

Returning to the reader's question (you thought I was drifting off course, didn't you?) will provide a more accurate assessment of a position's return. To begin with:

The margin requirement for selling an uncovered or "naked" put is the greater of 1) 20% of the stock price plus the put premium less the amount that the put is out of the money, or 2) 10% of the stock price plus the put premium.

In the XYZ example above, the margin requirement equation is (0.20 x 47 + 1.50) -2 = 8.90, or $890 per put sold. (The latter formula results in a requirement of just $620, which is obviously the lesser of the two, and therefore not applicable.)

Use the margin requirement as the basis for calculating the return on investment, or ROI, for the position. In our case, assuming the put expires worthless, the ROI would be 16.8%, which is derived from dividing the profit by the initial margin requirement ($150/$890). Remember that this was achieved in just a seven-week period and there is no reason or purpose for annualizing the return. Still, even without annualizing, this illustrates the leverage of options and the power of time decay.

To achieve a similar return through buying the underlying shares would have required $2,350 of initial capital (100 shares at $47 with a 50% margin requirement) and XYZ to climb by $3.95, or 8.4%, to $50.95.

This past article offers a discussion and some examples of how to employ selling puts as a means of establishing a bullish position.