Options offer investors a great variety of possible trades. In this article, I will describe how one can achieve 20% yield with the use of options. The trade should be adopted only for stocks which one strongly believes in and does not mind acquiring at lower than current levels.
When one strongly believes in a company, the simplest choice is to buy shares of the company. However, the most reliable stocks usually move slowly and do not exhibit exciting returns within a year. The trade suggested in this article involves placing a bull put spread of the stock. In my example, I will refer to BP (NYSE:BP), which I believe is a company that has left the worst beyond and is ready to turnaround. The effect of Macondo spill continuously fades now that earnings are proving sufficient to cover the damage. Earnings of 2011 were $25.7 B, which is in the range of Macondo charges. This means that BP just lost one year's earnings due to Macondo and now its market value has to catch up with its past performance (stock price was $60 before the accident, 50% higher than current value). The recent 14% increase in dividend (from $0.42 to $0.48 per quarter) and the announcement of a share repurchase program of $5.9 B constitute evidence that BP has retrieved financial strength.
According to the option prices at the close of 19/11 (taken from finance.yahoo.com), one can sell the April-2013 put options with strike $35 at 1.16 and buy the April-2013 put options with strike $33 at 0.83. The spot price was $40.03 at these prices. The net credit of this spread is 0.33, which means that the trader is paid $33 for each spread traded (each spread covers 100 BP stocks). The maximum risk is the difference between the two strikes ($2) minus the net credit ($0.33). Therefore, the maximum risk is $1.67 per spread. The possible outcomes depending on the price of BP stock on the expiration day of options (19-4-2013) are:
1. If BP stock is higher than $35, then the trader is rewarded $33 for each spread. This is an exceptional yield, almost 20% (33/167=19.8%) and is achieved even if the stock falls 12.5% from current levels (from $40 to $35). Even more important, this is by far the most probable outcome, as BP has not fallen below $36 in the last 52 weeks and touched $34 only for a few days within the last 2 years. In addition, if BP stock markedly increases after execution of the trade, one does not need to wait till expiration; one can close positions any time and secure the profit immediately. The yield will be less than 19.8% but the duration of the trade will be shorter, thus enhancing annualized yield.
2. If BP stock is between $34.67 and $35, the trader earns something between 0 and $33 per spread, respectively. The closer the price to $34.67 the closer the profit to zero.
3. If BP stock is between $33 and $34.67, the trader loses something between $167 and 0 per spread, respectively. The closer the price to $33 the closer the loss to $167. If BP stock is lower than $33, the loss is not greater; it remains $167 per spread, which is the maximum risk of the trade.
The 3rd outcome is the most undesired and the only one that involves loss for the trader. However, even in this scenario, which has by far the smallest probability of occurrence, there is a way for the trader to retrieve the lost capital. As soon as the trader realizes the loss on 19-4-2013, the next step is to sell the Jan-2014 BP put options that have strike $3 below the closing spot price on 19-4-2013. BP has not fallen below $30 for more than 15 years (with the exception of a few days just after Macondo accident) so it is rather safe that the trader will get his/her lost capital back with this trade. An alternative to outweigh the loss would be to buy BP shares at the prevailing levels (below $34.67) or, even better, sell BP puts of other strikes to essentially acquire BP shares at even lower levels.
To sum up, if BP stock increases, remains constant or falls even 12.5% from $40.03 down to $35 (but not lower), the trader earns 19.8% yield. This is by far the most probable outcome. If BP stock falls lower than $34.67, the trader realizes a loss but can retrieve the lost capital by selling Jan-14 puts with strike $30 or lower (the appropriate strike price to just breakeven will be about $3 below the closing spot price on 19-4-2013).
Note: One should try this trade only if one really believes in BP and only if one feels comfortable acquiring BP shares at levels below $33 in the worst case scenario (BP has not fallen below $34 in the last 2 years). The trade will prove a disaster if it is applied on a stock that will plunge with no return. That's why I strictly suggest it only for companies that have exhibited an improving earnings performance for more than a decade. BP, Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX) have exhibited improving earnings for more than the last 20 years. In addition, one should keep in mind that the exceptional yield 19.8% can be achieved only for a fraction of one's total capital. As with most trades, the trader should not allocate more than 6-8% of total capital on this trade because the trader should keep spare capital (earning interest on it) in order to outweigh losses in the worst case scenario. Of course the trade can be executed with different strike prices from the ones proposed above and with different stocks. If one wishes to be even more secure for avoidance of the bad scenario, one should use put options with lower strikes, in which case the yield will be lower. Nevertheless, the bad scenario is not that bad after all because it would give us the opportunity to buy BP shares at prices below $33, which is an exceptional bargain (it translates to trailing EPS 6.0 and dividend yield 6.5%).