Your analysis says Alpha Natural Resources (NYSE:ANR), Peabody (NYSE:BTU), Arch Coal (NYSE:ACI), Patriot Coal (PCX), and the coal ETF KOL are all cheap. At the same time, you're worried coal prices and these stocks could drop further. What do you do?
Consider this options strategy.
Investopedia notes about Put Writing:
A put is an option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying asset at a set price within a specified time. The buyer of a put option estimates that the underlying asset will drop below the exercise price before the expiration date.
When you write (sell) a put, you are on the other half of the trade. You have the obligation to buy a specific amount of the underlying at a set price. When a put is purchased, a premium is paid. As the writer of a put, you collect the premium.
There are two scenarios that can occur when writing a put. The first situation is the underlying share's price ends above the strike price for the put. If this happens, the put expires worthless, and the option writer keeps the premium. The second scenario is when the underlying share's price is below the strike price for the option. In this case, the option will be exercised, and the option writer will buy x amount of shares at the strike price. The option writer still keeps the premium in this scenario.
If you believe the underlying shares are a good deal at current prices, this is a way to buy them for less. You are buying the shares for the strike price - premium received. The downside is the option may never be exercised and you never end up owning the stock.
Now, let's look at an example with Alpha Natural: ANR Jan. 2013 $8 Put
The strike price is $8 and the current bid (the premium you will receive) is $1.64.
Most brokers will require you to have enough cash in your account to cover the option being exercised. Assuming 1 contract (100 shares) this amount will be $8 * 100 = $800. However, you are also being paid $1.64 * 100 = $164. So, you only need to set aside $636. $636 is the cost because you will not be able to use this money for anything else for as long as the option contract is open.
In scenario 1, ANR stays above $8, the option will not be exercised. Your return is the premium / cost = $164/$636 = 25.8%. Or 46% annualized.
In scenario 2, let's say ANR drops to $5. The option will be exercised and you will be required to pay $800 for 100 shares. You still keep the premium, so you end up with 100 shares you paid $636 for, or $6.36/share. The $5 is still less than $6.36, but you are down $1.36 a share (assuming ANR is currently trading at $8.55) instead of $8.55 - $5.00 = $3.55 /share; you would have been had you purchased the stock at its current price.
Your maximum gain is going to be 25.8%. Even if ANR goes to $100 a share, you are limiting your upside by employing this strategy. Remember to factor in transaction fees and taxes when you are performing your own calculations.
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.