Selling naked puts is a great way to purchase shares in companies you like at a predetermined price. In essence, you are getting paid to put in a "limit order."
An investor usually sells a put option if his/her outlook on the underlying security is bullish. The buyer of the put option pays the seller a premium for the right to sell the shares at an agreed-upon price. If the stock does not trade at or below the agreed-upon price (strike price), the seller gets to keep the premium.
Benefits associated with selling naked puts
- In essence, you get paid for entering a "limit order" for a stock or stocks you would not mind owning.
- It allows one to generate income in a neutral or rising market.
- When you sell a naked put you are in a way acting like an insurance agent. The seller of the option agrees to buy the stock in the future if it drops to a certain level before the option expires. For this, you (the seller) are paid a premium upfront. If this strategy is repeated over and over again these premiums can really help boost you returns over time.
- Acquiring stocks via short puts is a widely used strategy by many retail traders and is considered to be one of the most conservative option strategies. This strategy is very similar to the covered call strategy.
- The safest option is to make sure the put is "cash secured." This simply means that you have enough cash in the account to purchase that specific stock if it trades below the strike price. Your final price would be a tad bit lower when you add the premium you were paid up front into the equation. For example, if you sold a put at a strike of 20 with two months of time left on it for $2.50; $250 per contract would be deposited in your account.
- Most put options expire worthless and time is on your side. Every day you profit via time decay as long as the stock price does not drop significantly. In the event it does drop below the strike you sold the put at, you get to buy a stock you like at the price you wanted. Time decay is the greatest in the front month.
The majority of traders opt to close the put out prior to expiration if they have the chance of buying it back at much lower price. For example, selling the put at $2.50 and buying it back at $0.50
Reasons to like McDonald's Corp (MCD):
- A strong levered free cash flow of $3.8 billion
- A splendid history of increasing dividends consecutively for 35 years
- A three year and five-year total return of 63% and 99% respectively
- Net income increased from $4.5 billion in 2009 to $5.5 billion in 2011
- A five-year dividend growth rate of 20%
- Cash flow per share increased from $5.21 in 2009 to $6.76 in 2011
- Annual EPS before NRI surged from $1.93 in 2009 to $5.27 in 2011
- A good payout ratio of 52%
- Year over year projected growth rates of 7.87% and 10.8% for 2012 and 2014 3 respectively
- A decent yield of 3.10
- An excellent interest coverage ratio of 15.33
- A good quick ratio of 1.22
- A 5 year ROE average of 31%
- A projected 3-5 year EPS estimated growth rate of 9.9%
McDonald's was covered in detail recently in an article titled McDonald's 1 Of 3 Interesting Long-Term Prospects To consider.
Suggested Put strategy for McDonald's Corp:
It has broken through its 200 moving day average (generally not a good sign as it suggests there is more downside) and if it closes today at 87.35 or lower it will have violated its two-year up trend line. The market in general has been closing down on higher volume and when it does rally the volume is generally much lower. All this suggests that there is still more downside action.
Divide your money into 2-3 lots; wait for a test of 84- 85 ranges and then sell puts at strikes you would not mind owning the stock at. The charts indicate that it has strong support 80-82 ranges.
Right now, it is trading at 87.35, and the Dec 2012 80 puts are trading in the 3.05-3.15 ranges and so if the stock trades below 85.00, these puts could end up trading in the 4.00 ranges. Today the stock is down $1.99 so far and the puts are up by 74 cents. So if it dipped to 84.50, it would shed almost 3.00, and the puts should rise by a $1.00 as long as the stock does not take a long time to get down to this range. In that case, one can always jump into the Jan 2013 puts.
For this example, we will assume that if the stock trades to 84.50, that we can sell the Dec 2012 80 puts for $4.00. For each contract sold, $400 will be deposited in your account. If the stock trades below 80, the shares could be assigned to your account. Your final price would be $76.00 (80.00 minus 4.00). If the stock does not trade below 80.00, you get to keep the premium for a gain of 5% in roughly months. This works out to a yearly yield of 10%, which is more than McDonald's Corp. There is nothing to prevent one from repeating this process again, which will either get you in the stock at a lower price or in fact, provide you with what amounts to a very nice dividend payment.
The markets are still in a corrective mode, but in the interim, some sort of relief rally could (key word being could) take hold as they are extremely oversold. Long-term investors can use strong pullbacks to slowly start deploying money into long-term investments. A great way to get into a stock at a price of your choosing is to sell puts at strikes you would not mind owning the stock at. Investors looking for other ideas might find these articles to be of interest: Halliburton: A Potentially Great Entry Point, Or The chance to earn 8% and Showdown: General Electric Vs. Honeywell.
This list of stocks is meant to serve as a starting point. Please do not treat this as a buying list. It is imperative that you do your due diligence and then determine if any of the above plays meet with your risk tolerance levels. The Latin maxim caveat emptor applies - let the buyer beware.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: EPS and Price vs industry charts obtained from zacks.com. A major portion of the historical data used in this article was obtained from zacks.com. Earnings vs expectations data sourced from smartmoney.com Options table data sourced from yahoofinance.com.