One of my favorite times to use options is after a company has a monumental blow up, when its stock price is beginning to recover, but before it is able to fully recover. Often times the most lucrative time to be an options seller is exactly in this moment when implied volatility is still very high and a seller of options can capture cash on both sides by being a seller of both upside calls and downside puts.
I'd like to offer an idea on how to use this strategy with Freeport McMoRan (NYSE: FCX). I'm going to assume that anyone that has stumbled across this article is aware of Freeport McMoRan and the problems it's been dealing with over the past year and a half. For anyone who wants more specific details about the financial health of the company, Here is an article that more directly focuses on the cash flow and balance sheet health of the company.
For those that are aware of Freeport McMoRan and its troubles and opportunities, if you have a good understanding of the options market I'd like to throw out an idea as to how to lock yourself into a 20%+ cash return on a purchase of the shares while still enjoying significant upside. It's a perfect strategy for someone who thinks that Freeport has very solid support at current prices and, while it has enormous long term upside potential, it may indeed take a some time to realize this upside as we wait for further repairs to the balance sheet and further upside to commodity prices.
The strategy I am recommending is to buy shares of Freeport McMoRan in 100 share increments. Then, using a margin account, sell upside calls with a 2018 expiration at the $15 strike. Also, sell downside puts with a 2018 expiration at the $8 strike. If you don't understand what I've just said, please use this as an opportunity to learn rather than a trading recommendation.
To the person who implements this strategy, the first thing they would do is buy FCX stock in some multiple of 100 shares. As of the time of this writing, Freeport is trading at $9.80, so each 100 shares would cost $980. Next, you would immediately sell the 2018 $15 call for the current bid of $90, and then sell the 2018 $8 put for the current bid of $133. After you execute these trades, you will have immediately received $223, or almost 23% of your investment back in cash. That cash is yours to do with what you will, but for now I recommend holding it.
For anyone using this article as an opportunity for learning, essentially what we've done is agree to sell our Freeport shares at $15 in about a year, and we've also agreed to buy more Freeport at $8 in about a year. Now, just because we have agreed to do this, does not mean that we will be required to do so. No one in their right mind would buy our FCX shares at $15 if the stock isn't above $15, as they could just buy in the open market and get a better price. On the other hand, no one in their right mind would sell us FCX shares at $8 if the stock isn't below $8, as they could just sell for a higher price in the open market. Since Freeport is currently neither below $8 nor above $15, these options have zero intrinsic value. They only have value because of implied volatility and the amount of time to expiration. This is essentially what you are selling as you implement this strategy.
At this point, we just watch and wait. Every day that we get closer to expiration, the time component of the option's value decays. Assuming Freeport continues to be a much more stable stock, thanks to the uncertainty clearing around its financial health, the implied volatility component also should decay. Over the next fourteen months, you simply wait.
There are a few potential outcomes here, and if you are not okay with all of them, please do not implement this strategy.
1) Freeport ends above $8 per share but below $15 at expiration.
In this scenario, both the puts and calls you sold all expire worthless. The money you received for selling them is yours to do whatever you want with. You have received almost 23% of your investment back in cash, and you still would own your Freeport shares. You are free to sell your shares, or continue to hold them. You could also implement a similar options strategy again.
2) Freeport ends below $8 per share at expiration.
In this scenario, you would be required to buy 100 more shares for each put contract you sold. Remember you were paid $133 for each contract you sold, so your net purchase price would be $667, or $6.67 per share. The calls you sold will have expired, and the $90 you collected for selling each call contract is yours to keep.
3) Freeport ends above $15 per share at expiration.
In this scenario, you sell your shares of Freeport at $15 per share, the puts you sold expire worthless, and you are completely out of the trade. You have $1,733 in cash from the sale of stock, plus the money collected from selling the options. This gives you a total return, excluding any dividends FCX may have paid, of $753 on your original purchase of $980. You would have a 77% return in just over one year.
As I said earlier, this is only a strategy to implement if you would be happy with any of the outcomes. For me personally, I'd be delighted to buy more Freeport with a cost basis of $6.67. While I personally believe Freeport is headed much higher than $15 long term, I do think it will take a couple of years to get there. By selling the $15 calls, you are trading potential future upside for cash today. In a perfect world, Freeport would end at or just under $15 per share, leaving all of the options you've sold to expire worthless, and still leaving you with the shares. In this situation, you could simply sell $20 calls instead of $15 calls, and you could perhaps sell $10 puts instead of $8. You'd collect even more cash and you'd still be participating in the upside of the stock price.
For those of you that would like to learn more about options, I recommend the Options Industry Council. For anyone with questions about this strategy, please feel free to comment below and I'll do my best to respond.
Disclosure: I am/we are long FCX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am currently short FCX puts and short FCX calls.