How Selling Puts Can Create a Margin of Safety

During their recent episode of the Value Options Letter and Acquirers Podcast, Travis and Carlisle discussed How Selling Puts Can Create a Margin of Safety. Here’s an excerpt from the episode:

[Tobias] So, there’s two things that we always look for when we’re looking at value options. So, this is distinct from folks who adjust trading options. We’re looking at the underlying business and making sure that it’s something we want to own at the adjusted price.

So, that’s the strike less any premium that we receive because we’re selling a put, which means we get the premium and they’re cash secured, which means you have to put the capital up. But you want to make sure that in the event that the stock price continues to decline, in which case the stock is put to you. So, you’re effectively buying it at that lower price, which is the strike, less the premium you’ve received.

So, that reduces the price even further. And so, that’s always going to be a price that you would want to own the stock at. And then on the other hand, you have the internal rate of return or the CAGR on the premium that you’re receiving because it’s cash secured.

So, there’s cash in the account and you’re receiving some premium on that. You’re making sure that you’re receiving enough of a return to justify the position, the risk that you’re taking. And so, whichever outcome happens, you get put the stock, you’re getting the stock at a good price or you don’t get put the stock, the option expires, worthless, in which case you just collect the premium and there’s no payment.