Did You 'Live On The Edge' And Sell These Puts?

by: The Financial Lexicon

A couple months ago, in "Living On The Edge: Selling Puts On 5 Stocks," I offered ideas for selling put options on any of five stocks that were trading under $5 per share and were of companies that at the time had negative earnings per share. As I mentioned at the time, "these stocks take the meaning of risk to a whole new level" and were only appropriate for investors with very high risk tolerances.

As a brief review, here are the five trades from the previous article:

Arena Pharmaceuticals (NASDAQ:ARNA) - sell the January 2012 $1 puts. Potential annualized return: 60%

USEC (USU) - sell the January 2012 $1 puts. Potential annualized return: 60%

Savient Pharmaceuticals (OTC:SVNT) - sell the December 2011 $2 puts. Potential annualized return: 52%

American Superconductor Corp. (NASDAQ:AMSC) - sell the December 2011 $3 puts. Potential annualized return: 40%

A123 Systems (AONE) - sell the December 2011 $2 puts. Potential annualized return: 97.5%

Now that option expiration day for January has come and gone, it is time to report on the outcome of the trades. Four of these ideas worked out to the fullest extent, as the puts for the strike prices in question all expired worthless (what you want to happen when shorting puts). An investor who sold the puts I discussed, in a cash account, on ARNA, USU, SVNT, or AMSC would have experienced an annualized gain of 40% to 60%, depending on the stock, and not been forced to purchase any of the securities. Additionally, none of the aforementioned four stocks ever even traded below the strike prices mentioned in my previous article.

The fifth stock, AONE, is currently trading at $2.22, 11% above the strike price sold on the December puts. However, with two trading days remaining until expiration, AONE dropped under $2 per share. Had an investor sold the puts and held them to expiration, he or she would have been assigned the shares with a $1.85 cost basis (ex-commissions). It took just 10 trading days for AONE to move back above $2 per share on its way to $2.46 a short-time later. The investor holding the assigned shares into the New Year could have realized quite a handsome profit (beyond the 15 cents collected on the puts), depending on when he or she decided to sell the shares.

However, with that said, I would like to use the example of AONE as an opportunity to discuss managing trades. I was watching AONE as it dipped below $2 per share on the Wednesday before December expiration. When this happened, an investor who sold the puts for 15 cents had the opportunity to exit the position at 15 cents (the offer on the puts at the time). This would have resulted in a loss on the trade only as great as the commissions. Furthermore, given the bid/ask spread at the time, there was an opportunity to search for hidden liquidity at 10 cents. I've had tremendous success over the years finding hidden liquidity in the options market and would have certainly tried to find it in this case if I were short those puts.

In terms of managing risk, which becomes extremely important when dealing with highly volatile stocks of companies with no earnings power, I would have exited the trade at 10 or 15 cents as the stock dipped below the $2 strike price on Wednesday, December 14, 2011. Certainly, the person holding on as the stock fell to $1.51 (the trading day after December's options expiration) before eventually climbing to $2.46 less than a month later could have made significant money on this trade. I just want to point out that when managing options trades heading in the wrong direction, there are sometimes other opportunities worth exploring versus holding on through expiration and hoping the stock rebounds.

On a different note, I recognize that annualized gains are ultimately most impressive when one can replicate them over an entire year rather than just a couple months of the year. It can get a bit tricky selling puts during the heart of earnings season, especially after a large multi-week rally in the major indices and with market-wide volatility having declined significantly from the last time I presented short put ideas. At this time, pending an increase in market-wide volatility, a pullback in the broader market averages, or a significant pullback in any of the highly volatile, speculative stocks I follow, there aren't any new short put trades I find compelling.

ARNA's $1 puts do not offer any kind of premium I find compelling prior to the FDA's Prescription Drug User Fee Act (PDUFA) target date of June 27, 2012 for ARNA's drug, Lorcaserin. Watching AONE nosedive from $2.12 to $1.51 in five trading days in December is enough to make me want to stay away from its $2 puts. AMSC has simply rallied too much, up more than 37% since January 9th alone, to find any of its put options compelling (the same goes for other speculative equities I follow). USU's put options all the way out to April are bidding no more than 5 cents at the $1 strike. That's not enough premium relative to the time frame for me.

Finally, SVNT is tempting. However, back in November, the market was offering 8 cents to sell the $2 puts expiring four weeks later. At the time, SVNT was trading at $2.52. This time, with the stock trading at $2.36, the market is offering only 4 cents to short the $2 puts expiring in three-and-a-half weeks. It's not quite where I would want it to be in terms of risk/reward, but for those who are interested in this idea, it would pay 2% over the next 25 days, a slightly-more-than 29.28% annualized return. The seller of those February 18, 2012 $2 puts would only be assigned shares (assuming the put position weren't already closed) if the stock closed more than 15.25% lower than its January 24, 2012 close.

If you are tempted to go out beyond the February options on SVNT, keep in mind that Savient will be reporting earnings towards the end of February. The March $2 puts have a wide bid/ask spread of 10 cents by 19 cents. If you are interested in selling those put options, consider searching for hidden liquidity around 13 or 14 cents.

If you are interested in short put opportunities on companies with different risk profiles than the type discussed in this article, please read my article "Options: Did You Catch These Falling Knives?" which offers three current short put ideas.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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