A Safe Options Strategy for First Magestic Silver

Jun.15.11 | About: First Majestic (AG)

During a downtrend market, it has be hard to keep your portfolio out of the red. There are still a few opportunities out there but most of them are still feeling an impact of the broader market. Another route you could try is defensive stocks like Coca-Cola (NYSE:KO), Procter & Gamble (NYSE:PG), Clorox (NYSE:CLX) or iShares Healthcare ETF (NYSEARCA:IYH). However, don't expect any spectacular gains from these companies.

One of the best ways to make money in any market, including a down market, is to sell put options. Selling put options provides you with upfront money and can be a very conservative strategy, if you do it right. First, let's remind ourselves of what selling puts actually is:

A naked put is a put option where the option writer does not have a position in the underlying stock or other instrument. This strategy is best used by investors who want to accumulate a position in the underlying stock - but only if the price is low enough. If the investor fails to buy the shares, then he keeps the option premium.

This means that you are the seller of the put option and you benefit when the value of the put rises. Remember that since you are a seller, time is on your side.

This is just a very basic overview of what a naked put is. I suggest that if you are not familiar with naked puts you should do more research and become comfortable with the strategy.

Make sure you understand the risks before you begin selling puts: Be sure to pick stocks that you would not mind owning in the event of an exercise. Also, be sure your brokerage account allows you to sell options along with enough cash on the sidelines to pay for the stock in the event of the exercise. That means, for example, don't sell Apple (NASDAQ:AAPL) puts unless you have at least $30,000 to cover in the event of an exercise.

Now lets take a look at how selling puts can be a conservative, income oriented, options strategy.

  1. Look for a stock that has had a high percentage loss on the day. This can be viewed on most financial websites. The website I go to is Yahoo Finance.

  2. Search through the high losers of the day and look for any familiar companies that are sound and stable but may have missed earnings a little or were downgraded by an analyst.

  3. Once you have found a stock, be sure to check the headlines of the day and find out why the stock fell. You want to make sure there isn't a significant flaw in the company.

  4. Check out the "Key Statistics" (if you are using Yahoo Finance) of the stock you have selected. Go through the list. Look for any absurd valuations such as a high P/E, high debt, low ROE, etc.

  5. If all statistics are within reason, go to the options page and look for an ideal strike that is Out-of-the-Money (OTM). This means you shouldmake sure the strike price is lower than the current market price.

  6. Once you have found a strike that represents your outlook (I prefer to have a longer term expiration), go to the CBOE website and go to "option calculator". Now calculate to find the option's Delta and Implied Volatility.

  7. Here is how you know you have a winning option:

Delta: Between .10 and .25 (10% and 25%, respectfully)

The word delta comes from the Greek alphabet, and it represents the option's price in relation to the underlying stock's price. The delta is important because it tells the option seller the chances of exercise and whether he will be forced to buy the stock at the strike price.

If you follow this procedure, you will be able to find good opportunities to sell puts for income, with little risk of getting exercised on.

Now to put the procedure above in real context, here is a trade I recommend. I recommend selling First Majestic Silver Corp (NYSE:AG) October 12.50 puts for about .70, at the time of this writing.

First Majestic Silver Corp lost 8% on June 13 based on speculation that China could affect prices. I found this stock in the large percent losers category of Yahoo Finance. I checked out its "Key Statistics" and all were in the range of normal. Of the options that are available to the stock, I found the 12.50 strike to be conservative yet rewarding.

The CBOE options calculator is my favorite tool when it comes to finding out about volatility for options. In this case I wanted to calculate my delta, which came out to be .19. This means there is an 81% chance this option will not be exercised, thereby leaving you with profit from the premium you received and the profit you would receive if the stock stays unchanged or moderately higher by expiration. Also, since you received .70 ($70) to sell the put, your B.E.P. (break even point) comes out to $11.80. That means you don't start losing money until the stock tanks to $11.80. The stock currently trades at $17.28. The likelihood of this stock dropping by $5.48 is highly unlikely.

As you can tell from above, it isn't hard to find good, conservative opportunities to sell puts. Selling puts can be a rewarding experience if you limit the risk by selling a put that is Out-of-the-Money with a longer term expiration date. This will ensure your safety from exercise. As a reminder, please investigate the trade recommendation on your own before investing, as well as understanding the risks involved with selling puts. Selling puts are a great way to create consistent income in any market.

References: Investopedia

Disclosure: I am short AG.with sold AG Octoer 12.50 Puts.