Using Cash-Secured Puts to Play 3 Popular Stocks

|
 |  Includes: AAPL, BBRY, SIRI
by: Vince Martin

I wrote on Friday about the opportunities presented in the US equity market by the recent 10% correction. While economic data and the stock market rattle investors' nerves, there are 2 advantages to the current situation for investors with cash on hand:

1. Stocks are lower than they were two weeks ago, allowing us to buy at a discount.

2. Less obviously, increased market volatility leads to increased option prices, which leads to more effective hedging strategies. The CBOE Market Volatility Index, more commonly known as the VIX, measures implied volatility for S&P options for the coming month. It, as one would expect, has spiked dramatically during the recent correction:

30-day VIX chartClick to enlarge
(30-day VIX chart courtesy Yahoo! Finance)

Higher volatility means higher option premiums. Many investors are aware of covered calls, in which they sell an out-of-the money call option on existing stock, trading upward gains for an option premium to use as downside protection. For instance, a holder of Apple (NASDAQ:AAPL) at Friday's close of $373.62 could sell a short-term September 390 call for $10.20. This trade provides nearly 3% in downside protection, should the market further correct. As a trade-off, the investor loses any upside should the stock reach over $400.20 before expiration.

Less well-known, and well-utilized, is the practice of selling cash-secured puts on unowned stocks. While the two trades are equivalent (scroll to the middle for my explanation of options equivalence), cash-secured puts are simpler, easier to understand and may save on commission or on spreads when using limit orders relative to covered calls.

Cash-secured puts are very simple: the investor sells an out-of-the money put option, making sure to keep the cash in the account to cover the capital at risk. For instance, if an investor sells a December 10 put on XYZ for $1.00, the investor will keep $900 in cash in the account. (Some brokerages will also pay interest on the balance, though at modern rates the interest is essentially negligible.) It is very important for most investors to secure the puts with cash. Selling naked puts is a risky strategy for experienced option traders; potential losses are multiples of potential gains. Selling a naked put on XYZ has a maximum gain of $100, with a maximum loss of $900. Those kind of risks are not suitable for the majority of individual investors.

Out-of-the-money cash-secured puts are a hedged bull play; our upside is capped at the option premium received. If XYZ goes from $12 to $11, our December put option expires worthless, and we receive $100 on the trade. If XYZ goes from $12 to $1,100, our put option expires still expires worthless and we still receive $100. As such, if you believe that the short-term correction of the last two weeks will reverse quickly, this is not the trade for you. Straight stock purchases, or for the more speculative minded, purchasing out-of-the-money calls will provide greater returns in a strong market rebound.

If, however, you are worried about short-term or medium-term weakness in the market, the hedge of the option premium plus the fact that we are selling the puts out-of-the-money gives a substantial cushion. The idea is to set a strike price for the put at which you are comfortable -- even happy -- owning the stock.

The strategy is not fool-proof, of course, as the biggest risk is that the same piece of news that drives the stock price down to the exercise price is the same piece of news that changes your investment thesis. (Of course, this can happen when owning stocks outright as well.) But, as in a covered call, we are sacrificing upside for cushion to the downside. And since volatility has spiked, we can get more cushion.

As such, here are 3 examples of popular stocks that can be played with a cash-secured put. Please note that these are not solid recommendations, but rather examples of the strategy for varying underlying equities. For each underlying stock, I've offered four variations: a short-term aggressive trade, a short-term conservative trade, and a medium-term aggressive and conservative trade. These too are just data points, not strong recommendations. Which trade you select depends on your risk tolerance, your investment objectives, and your feeling about the broad market and the stock itself.

1. Apple (AAPL)
Friday's close: $373.62


I don't know what else to say about Apple, besides the fact that is now trading below where it was before late July earnings, when the company grew revenue 82% off a year-ago base of $15.7 billion. Think about that: 82 percent growth in a year, off a base of $15.7 billion. It's an astounding, and still underrated, accomplishment.

Short-term Aggressive: Sell October 360 put at $19.15. A 5.6% return on a 10-week trade, or 29% annualized (all annualized figures are computing using the Monday after expiration). Downside is owning AAPL at $340.85, 8.8% off current levels.

Short-term Conservative: Sell September 310 put at $3.20. A 1.04% return on a 6-week trade, or 9% annualized. Downside is owning AAPL at $306.80, 17% off current levels, and nearly 25% off post-earnings highs.

Medium-Term Aggressive: Sell January 360 put at $29.20. A 8.8% return on a 24-week trade, or 19% annualized. Downside is owning AAPL at $330.80, 11.4% off current levels.

Medium-Term Conservative: Sell April 300 put at $16.60. A 5.9% return on a 37-week trade, or 8.2% annualized. Downside is owning AAPL at $283.40, 24% off current levels.

2. Sirius XM Radio Inc. (NASDAQ:SIRI)
Friday's close: $1.89


Sirius has been well-covered by SA's Rocco Pendola and Cameron Kaine, among many others, so I will leave the details of the bull case to them and the other fine writers on this site. (Click on the SIRI link above for full coverage.) SIRI also has an incredibly large, incredibly loyal following among retail investors, and an ugly short-term chart (off 20% since hitting resistance in early June), so I feel many SA readers might be interested in hedged long positions on SIRI.

Short-Term Aggressive: Sell September 2 put for 24 cents. We are taking away our cushion on this trade; maximum gain occurs with a 6% rebound in the underlying stock over $2.00, in which case we make a handsome 14.5% return, or 126% annualized. If the stock stays flat, we make 13 cents per contract, or 7.9% (68% annualized). Downside is owning SIRI at $1.76, 6.8% below current levels and 35% below early June highs.

Short-Term Conservative: Sell December 1.50 put for 11 cents. A 7.9% return on a 20-week trade, or 20.5% annualized. Downside is owning SIRI at $1.39, 26% below current levels (in 20 weeks!)

Medium-Term Aggressive: Sell January 2 put for 38 cents. Once again, we require a gain in the underlying stock. A 6% rebound over $2 returns 23.4% on a 24-week trade, right at 50% annualized. Downside is owning SIRI at $1.62, 14% below current levels.

Long-Term Conservative: Sell January 13 LEAP 1 put for 11 cents. Return is 12.3% on a 76-week trade, or 8.4% annualized. Downside is owning SIRI at 89 cents, 53% below current levels.

3. Research in Motion (RIMM)
Friday's Close: $23.39


Ah, now it gets interesting. I'm not all that big a fan of RIMM, but as the company continues to slide, at some point a bad company may become a good stock. Again, this is not a recommendation, but RIMM bulls can use cash-secured puts to set up very low entry prices into the stock.

Short-Term Aggressive: Sell September 20 put for 98 cents. A 5.1% return on a 6-week trade, or 44.6% annualized. Downside is owning RIMM at $19.02, 18.7% below current levels

Short-Term Conservative: Sell September 15 put for 23 cents. A 1.5% return on a 6-week trade, or 13.5% annualized. Downside is owning RIMM at $14.77, 37% below current levels

Medium-Term Aggressive: Sell March 22.5 put for $3.85. A 20.6% return on a 33-week trade, or 32.5% annualized. Downside is owning RIMM at $18.65, 20% below current levels.

Medium-Term Conservative: Sell March 15 put for $1.08. A 7.7% return on a 33-week trade, or 12.2% annualized. Downside is owning RIMM at 13.92, 40% below current levels.

Once again, cash-secured puts are not a foolproof strategy. If we do see a sharp rebound in the market, investors can miss out on the upside, and have capital locked up until expiration, or be forced to buy the puts back in order to free up cash for additional opportunities. However, for investors nervous about the market, or willing to sacrifice gains for capital preservation, the recent downturn and spike in volatility offer some good hedged bull plays on US equities.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AAPL, SIRI over the next 72 hours.

Additional disclosure: I may also make options trades on AAPL, SIRI, or RIMM this week, which may include bearish or bullish positions.