I am a big fan of writing cash-covered out-of-the-money put options on stocks to generate income. It is a strategy that if executed with discipline can generate income in bear, bull and flat markets. It is akin to an insurance business. However, unlike an insurance underwriter, you do not get to name your own price when selling options as a retail investor. You either write at market prices or not write at all. That is why it is crucial to be selective.
The decision to sell a particular option always depends on three factors: price, likelihood of adverse outcome, and size of potential losses. One should only consider writing an option if price more compensates for the potential adverse outcome.
Broadly speaking, weighing option prices against potential for adverse outcome (losses) is a complicated task. It requires skills and resources that few retail investors possess. However, retail investors can still profit from writing options if they focus on companies that they know well from an investment perspective.
For the most part, I write options exclusively on stocks that I believe to be great investments at or below strike price of options I sell. This way, I minimize adverse outcomes for myself. I am happy if my short put option positions expire worthless on expiry day and I get to keep the option premiums. I am equally happy (usually at least) if the stock is put to me at the strike price.
I have shared some of my current favorite trades below. I have selected underlying stocks with a strong balance sheet, positive cash-flow, high ratio of tangible book value to share price, and consolidating share prices.
- Corning (GLW): Corning is a manufacturer of glasses, ceramics, and related products. Its biggest business divisions are display technologies (glass substrates for flat-panel screens), telecommunications (fiber optic cables), and life sciences (lab equipment). Corning shares have tumbled in the past 12 months mainly because of weakness in demand from LCD TV manufacturers. Corning's other business segments are doing well. It has a fortress balance-sheet, a tangible book value of $13.30/share and a dividend yield of more than 2%. Corning's return on assets (ROA) and return on equity (ROE) for the last five years, not including a one-time tax benefit in 2008, have averaged 14% and 20% respectively. Last but not least, company is buying back shares. My trade: Sell $13 August 2012 puts for $0.85/share (closing option price on April 23, 2012).
- Carnival Cruise Lines (CCL): Carnival is the largest cruise-line operator in the world. The shares have been underperforming both as the result of the tragic Costa Concordia accident, and the weak economy in Europe. However, the company has a long history of profitability and strong cash flow generation. ROA and ROE for the past five years have averaged 6% and 10% respectively. The dividend yield of more than 3% is very well supported by cash flow from operations (more than $4/share in 2011). Tangible book is approximately $25/share. My trade: Sell October $26 puts for $1/share (closing option price on April 23, 2012).
- Yahoo! (YHOO): As I explained here before, Yahoo owns valuable assets in Asia. In all likelihood, sum of Yahoo's parts are worth more than current stock price. That aside, Yahoo is profitable, has a solid balance sheet, generates good cash flow, and has been using its cash to aggressively buy back its own stock. My trade: Sell July 14 puts for $0.38/share (closing option price on April 23, 2012).
- Research in Motion (RIMM): The BlackBerry maker's shares have plummeted over the last year due to slowing sales and intensifying competition from Apple (AAPL) and Android. However, As I argue here, I believe company's challenges are already reflected in its share price. Current share price is also supported by the company's strong balance sheet, tangible assets, and recurring service revenue. Furthermore, the negative sentiment on the stock has pushed up option premiums, which could potentially reward the brave put-sellers. My Trade: Sell December $10 put options for $1/share (closing option price on April 23, 2012).
For any of these trades, unless facts change or new information refutes my investment thesis, I would hold my position until expiry. If I am required to buy the shares at strike price, I will be happy to do so.
Disclosure: I have a short position in put options on GLW, CCL, YHOO, and RIMM.