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Given the heightened uncertainty surrounding the world economy, as well as events out of Europe, investors might be reluctant to purchase stocks. Investors might be especially hesitant to purchase stocks that have increased significantly, in some cases by multiples, since the bear market low of 2009. For these investors, selling out-of-the-money puts could be the appropriate alternative, allowing some exposure to equities while also providing some downside protection. The downside protection would result from not purchasing the stock outright, but instead agreeing to purchase it at a price below the current market price.

The following list consists of companies whose stocks have simply gotten crushed this year or whose stocks are trading at or near their 2007-2009 bear market lows. While there may be good reasons for each of these stocks to be trading where they are today, the question is how long this onslaught of selling will continue. Buying the stocks of so called “falling knives” is certainly not for the faint of heart. However, if you think these companies have viable ongoing businesses and are not in a situation where they need to dilute shareholders into oblivion, then selling out-of-the-money puts is a way to gain exposure to equities while taking advantage of the higher volatility in these stocks.

Without further ado, they are:

Computer Sciences (CSC) closed at $25.15 on November 17, down 55.57% from its 2011 high of $56.61. During the bear market that ended in 2002, it bottomed at $24.30, and during the most recent bear market, it bottomed at $23.93. Normally, one might consider targeting the next lowest strike price below $23.93, which is the $22.50 puts. However, because of the elevated volatility this stock displays, you could go all the way down to the $20 strike on the January 2012 puts and sell them for 85 cents.

If on January option expiration day, the stock closes no more than 20.47% lower than its November 17 close, the puts will expire worthless and you will keep the entire premium. If it closes below $20, you will be assigned the shares (assuming you haven’t already closed the position) and your cost basis, ex-commissions, will be $19.15 ($20 minus 85 cents). Assuming the puts expire worthless, in a cash account, this trade will bring in 4.25% in two months, for a 25.5% annualized yield.

Molycorp (MCP) closed at $30.35 on November 17, down 61.66% from its 2011 high of $79.16. Molycorp’s stock does not have a long history as it only first started trading on July 29, 2010. In its short history, MCP reached a low of $12.10, which happened to be on the day of its IPO. In November 2010, MCP put in a bottom of $26.90 before heading up to $79.16 this past May. Normally, one might consider targeting the next lowest strike price below $26.90, which is the $25 puts.

However, because of the extreme volatility on this stock, you could go all the way down to the $20 strike on the January 2012 puts and sell them for 88 cents. If on January option expiration day, the stock closes no more than 31.10% lower than its November 17 close, the puts will expire worthless and you will keep the entire premium. If it closes below $20, you will be assigned the shares (assuming you haven’t already closed the position) and your cost basis, ex-commissions, will be $19.12 ($20 minus 88 cents). Assuming the puts expire worthless, in a cash account, this trade will bring in 4.40% in two months, for a 26.4% annualized yield.

Sony Corporation (SNE) closed at $16.80 on November 17, down 54.56% from its 2011 high of $36.97. During the bear market that ended in 2009, SNE bottomed at $15.64. The last time the stock had seen those levels was in 1992 during a multi-month consolidation period. As a result of the multi-decade support in the $15 to $16 region, you could consider selling the January 2012 $15 puts at the current bid of 50 cents.

If on January option expiration day, the stock closes no more than 10.71% lower than its November 17 close, the puts will expire worthless and you will keep the entire premium. If it closes below $15, you will be assigned the shares (assuming you haven’t already closed the position) and your cost basis, ex-commissions, will be $14.50 ($15 minus 50 cents). Assuming the puts expire worthless, in a cash account, this trade will bring in 3.33% in two months, for a 20% annualized yield.

Diamond Foods (DMND) closed at $36.62 on November 17, down 61.9% from its September 21, 2011 high. During the bear market ending in 2009, the stock sold down to $18.39. This stock has gotten crushed on news that its acquisition of Pringles from The Proctor & Gamble Company (PG) is being delayed due to accounting improprieties Diamond Foods is investigating. Furthermore, this stock is very heavily shorted. While some might view this as a potentially bullish setup, highly shorted stocks in “falling knife” mode can be quite dangerous to catch. The option chain on DMND does not include January 2012 options.

If you go out just one month to the December 2011 options, there is an opportunity to sell the $25 puts for 50 cents. If on December option expiration day, the stock closes no more than 31.73% lower than its November 17 close, the puts will expire worthless and you will keep the entire premium. If it closes below $25, you will be assigned the shares (assuming you haven’t already closed the position) and your cost basis, ex-commissions, will be $24.50 ($25 minus 50 cents). Assuming the puts expire worthless, in a cash account, this trade will bring in 2% in one month, for a 24% annualized yield.

MGIC Investment Corporation (MTG) closed at $2.75 on November 17, down 76.68% from its 2011 high of $11.79. In March 2009, the stock bottomed at $0.6999, and its 2011 low is $1.51. If you like to follow in the footsteps of well-known hedge fund managers, you might be interested in knowing that Kyle Bass of Hayman Capital Management L.P. recently purchased a 4.9% equity stake in MGIC. Given the stock’s October 4, 2011 low of $1.51, you could consider selling the January 2012 $1.50 puts for 14 cents.

If on January option expiration day, the stock closes no more than 45.45% lower than its November 17 close, the puts will expire worthless and you will keep the entire premium. If it closes below $1.50, you will be assigned the shares (assuming you haven’t already closed the position) and your cost basis, ex-commissions, will be $1.36 ($1.50 minus 14 cents). Assuming the puts expire worthless, in a cash account, this trade will bring in 9.33% in two months, for a 55.98% annualized yield.

Bank of America (BAC) closed at $5.80 on November 17, down 62.12% from its 2011 high of $15.31. In February 2009, BAC traded as low as $2.53, while its 2011 low is $5.13. For those of you who can’t get enough of the financial stocks and have more courage than I, you could consider splitting the difference between those two lows and selling the January 2012 $4 puts for 15 cents.

If on January option expiration day, the stock closes no more than 31.03% lower than its November 17 close, the puts will expire worthless and you will keep the entire premium. If it closes below $4.00, you will be assigned the shares (assuming you haven’t already closed the position) and your cost basis, ex-commissions, will be $3.85 ($4.00 minus 15 cents). Assuming the puts expire worthless, in a cash account, this trade will bring in 3.75% in two months, for a 22.50% annualized yield.

A word of caution: should there be a liquidity-crushing event that materializes in the next two months, similar to the crash of 2008, support levels will likely not matter. Furthermore, market-wide volatility would likely spike, thereby increasing option premiums and, on a mark-to-market basis, work against someone who is short puts.

Source: Catch These Falling Knives By Selling Puts