My past experience with options has always been in purchasing call options. About 2 weeks ago, I put through my first trade of selling put options. The key objective for selling options is to generate income for the portfolio. A safe bet tends to be the selling of put options at a strike price which one does not mind owning the underlying stock, in the event the counter party exercises the option.
The underlying stock in question is Verisign which I have held for more than a year. I continue to like the business immensely. Verisign holds the .com domain monopoly – Warren Buffett’s proverbial toll bridge. To put it simply, every company in the world that wishes to register a .com, whether it’s Apple, Google or Microsoft, ultimately has to pay an annual fee indirectly to Verisign.
In my investment thesis writeup on Verisign, I noted that the agreement with the Internet Corporation for Assigned Names and Numbers (“ICANN”) to maintain Verisign’s monopoly is ironclad since there is an automatic renewal mechanism as long as Verisign does not screw up its maintenance of the root zone files. On 20 October 2016, that agreement was extended till 2024. The agreement was originally due for extension only in 2018. That it will ultimately be extended isn’t a surprise for me, but to the rest of the market, the renewal probably provided extra clarity and was a nice surprise given how early it got renewed.
That event sent the stock price up 6.5%, from US$76.56 to US$81.56 though it has since came back down to US$76.47 as at 26 December 2016.
The details of the option in question is a premium of US$3.50 at a strike price of US$65.00 and has its expiry on January 2018 or about 12 to 13 months from now. At the point of selling the put options on 19 December 2016, the stock price was about US$78.20. The stock price has to fall about 21% from US$78.20 to US$61.50 before the puts will be exercised by the counter party.
Given my belief that Verisign’s business will continue to be strong and generate the adjusted free cash flows at more or less the same amount even in bad times, I would be glad and very comfortable owning the stock at lower valuations. The way I see it, Verisign’s stock is a bond-like instrument with a small growth component embedded.
At a stock price of US$78.20, it is trading at a rather acceptable EV / adjusted TTM FCF (excludes stock-based compensation) of 13.9x or a yield of 7.2%.
Should the stock price fall 21% to US$61.50 when the put options become exercisable, the stock’s yield would now be about 9.0%. This compares favourably to the risk-free 10-year and 30-year US government bonds yields of about 2.5% and 3.1% respectively. While I know perfectly well that these are not exactly apples-to-apples comparison, and that Verisign isn’t risk-free (though I think it comes quite close), I thought it is still useful and a good enough shorthand to know that Verisign will be yielding about 2.9 to 3.6 times that of the risk-free rate.
All in all, the premium collected will amount to an annualised return of about 5.2% based on the capital-at-risk.
5.2% is certainly nothing to shout out about as compared to most option traders’ double digit annualised returns. However, the structure of this trade is one that I can go to sleep at night soundly in even if the put options are exercised. Considering the insomniac I am, I would rather choose this over nail biting and exhilarating option trades that will leave me sleepless at night.
I am not sure if Verisign’s stock price will fall below US$61.50 over the next 12 to 13 months but even if it does, I would be a happy camper, assuming there aren’t significant adverse changes to the nature of the business. In the meantime, I’m glad to sit around and collect my US$3.50 in premiums!