What Is 'Margin of Safety' and Why Is It Important?

I often mention margin of safety in my option trading discussions. It's a key concept, yet I still get questions about it on a regular basis. Let's define the term. Margin of safety equals the maximum percentage decline from a stock's trade inception price that could occur without causing a loss. It is generated from basic stock ownership accompanied by short sales of options relating to that same underlying security. Simply buying shares outright provides no protection against potential declines. Buyers of options, be they calls or puts, pay time premium and thus have staggers to make up before even reaching break-even points (if the options are then held to maturity). Paying for time means forgoing any margin of safety. It actually imposes a hurdle to simply get all your original money back. For that reason, I rarely recommend buying options. Sellers of options are always on the receiving end of time premium. That ensures they'll have a predetermined share price cushion before incurring any losses. Longer-dated options typically provide the highest time premiums while delivering the largest safety buffers. They also allow more time for profitable companies to increase their intrinsic values prior to the option expiration dates. Why are margins of safety so desirable? Trades do no always go according to plan. It is quite comforting to know that you could absorb anything but a major hit to the underlying shares without suffering any loss. Here are some examples of actually available trades and how margin of safety is determined. I wrote recently about all the positive factors now for specialty retailer Children's Place . I expect PLCE to be much, much higher by January of 2023. Here was the pricing on its shares and LEAP put options out to Jan. 20, 2023 with PLCE at $82.05. The very conservative, well out-of-the-money $70 put was paying $16.65 per share or $1,665 per 100-share commitment. The worst-case, if exercised price dropped to just $53.35 providing an almost 35% margin of safety versus the trade inception price. The most aggressive, deep-in-the-money strike prices shown ($100 puts) paid a whopping $33.82 per share. Break-even was set at $66.18, about 19.3% below PLCE's trade inception price. How cool is it to know that you could be very wrong in your assumption of future price performance yet still be protected against all but a very major price decline? The $70, $80 and $90 strike price puts provided bear-market sized protection ranging from 24.4% to 34.9%. Selling long-dated puts can morph even small upturns into very substantial profits. It can translate flat share price performance into solid gains. Shorting LEAP puts can even turn modest declines in the underlying shares into nicely positive returns. Trucking firm Knight Swift Transportation reported better than expected EPS and revenues on July 21, 2021. The shares inexplicably sold off sharply. That's a perfect set up for those looking for long-term put exposure. Here was the pricing on its shares and Jan. 20, 2023 expiration date, $45, $50 and $55 puts with KNX at $46.76. KNX is less volatile than PLCE. Its options still provided from 7.1% to 16.0% margins of safety from the already cheap trade inception price. I expect Knight Swift to be well over $55 well before the option expiration date. Maximum gains on these, or any other option sales, always equals keeping 100% of all premium collected up front. In these particular examples that would be either $572, $848 or $1,160 per each 100-share, one-contract commitment. Shoe designer/retailer Caleres has LEAP options out to Dec. 16, 2022. I'm very bullish on its future prospects so I'd recommend shorting its $25, $30 or $35 strike prices as illustrated below. Worst-case, forced purchase prices dropped to between $17.50 and $20.00, depending on the strike price(s) selected. CAL could drop by from 18.6% to 28.8% without causing losses. Maximum gains would run from $750 to $1,500 per each 100-share, one-contract commitment. Current analyst estimates for CAL run about $2.24 for fiscal 2021 (ends Jan. 28, 2022) and $2.65 for fiscal 2022 (ends Jan. 2023) shortly after these options would reach expiration day. Implied price-to-earnings on the most conservative strike price puts would be just 7.8-times on this year's EPS and just 6.6-times expected EPS for fiscal 2022. Selling LEAP puts is a great way to supplement a diversified stock portfolio to, hopefully, contribute to much higher total returns than are available with plain vanilla techniques. LEAP Put Sales: Bring in immediate income Provide excellent downside protection Often allow for legally deferring tax liabilities for up to three years How can they defer taxes? Money received from short sales of options do not become taxable events until they are bought to close or expire. Any gains on January 2023 puts, which are held through expiration will not be reportable until filing your 2023 tax-year schedule-D in April of 2024.

What Is 'Margin of Safety' and Why Is It Important?

This is a key concept to investing, yet I still get questions about it often. Let me explain what it is and how to use it to your advantage.

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