By Mark Bern, CPA CFA
I recently published another article on British Petroleum's (NYSE:BP) plights that are hammering the stock price. I expect the company to be able to handle those issues and have a clean slate by the end of 2012. I also believe the company has the potential to trade near $48 a share by the end of 2013. For more on how I expect BP to accomplish all that please refer to my article "Beyond Petroleum or Bargain Price?" at this link. But this article is more of an explanation of how to profit now (and possibly in the future) by selling one or more puts on BP before the company has a chance to recover. It is not often that I find the opportunity to make 5% return on my cash in about a month-and-a-half's time.
First of all let me provide a brief explanation of the purpose and process of a transaction to sell (sometimes called writing) a put option and include a few rules. I'll start with some rules and explanations about how options work.
I sell cash secured puts on companies that I would like to buy only. I never sell a put on a company strictly for speculation purposes, especially when I would not want to own the company as a long-term investment. If you don't want to own BP stock you should read my other article before continuing. If you have already read my other article and still don't want to own BP stock, then there is no need to continue unless, perhaps, you just want to learn more about profiting from selling put options.
Also, the vast majority of options contracts expire worthless. That means that one side made money and the other side lost money. The side that makes money in the majority of options transactions is the seller (or writer) of the cash-secured put(s). The loser, obviously, is the one who paid the seller for the right to buy or sell the underlying security within a specific time frame.
If the price on the stock drops below the strike price on the options contract and remains there at the contract expiration date, the option will be exercised and the seller will be obligated to purchase the stock for the strike price. If the price remains above the strike price at the contract expiration date, it is highly likely that the option will expire worthless. If the contract has not been exercised by expiration, the odds of the contract expiring worthless is nearly 100%. I have never personally been put a stock at expiration when the price was above the strike price.
You also should be aware that to sell a cash-secured put you will need to have enough cash (or, depending on your brokerage, enough buying power) available in your account to purchase the stock in the event that the option is exercised. In the example I am about to explain, for each contract we sell we would need $3,800 in our account. For a more detailed explanation of selling puts and calls please refer to the article, "My Long-Term, Enhanced Investing-for-Income Strategy."
What is so special about BP right now? I want to make you aware of a rare opportunity to either lock in a nice profit of 5.2% for a 43-day holding period or become an owner of BP stock at about 7% below the current market price. The put option contract I like today is the July option with a $38 strike price and a premium of $2.09. In other words, if you sell this put at this price you collect $209, less a commission (usually less that $9) to net $200 for a 5.2% return immediately, or a 41.3% annualized return. I usually calculate the annual return a little more conservatively, because being able to reinvest your money in puts more often that 10 months out of the year is difficult. Thus, I would assume that we could reinvest the proceeds five more times instead of eight times, resulting in an annualized return of 26%. This is the return you can expect if the contract expires worthless.
If the stock price drops below the strike, a real possibility, your cost basis would be $35.91 a share ($38 - $2.09), which represents a discount from the current price of 6.7%. I don't mind holding a stock I believe will appreciated nicely in the next 18 months and pays a 5.2% dividend yield while I wait.
Oil prices are not likely to fall much, if any, further, in my opinion. Saudi Arabia holds the only excess production capacity of available oil and the $80 price is where I believe the Saudis will draw the line. The can effectively control the price by reducing production because they control the balance between supply and demand. If demand wanes slightly, as has happened lately, the Saudis will, again in my opinion, prop up prices. Only if demand drops significantly for an extended period would the Saudis have difficulty holding the price of oil at around the $80 level. But oil demand will continue to climb over the long term and the price will rise with it, along with the revenues of oil companies like BP.
Additional disclosure: I may sell options on BP over the next 24 hours.