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Selling puts is a great way to purchase shares in companies you like at a predetermined price. In essence, you get 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 puts

1. In essence, you get paid for entering a "limit order" for a stock or stocks you would not mind owning.

2. It allows one to generate income in a neutral or rising market.

3. 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.

4. 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.

5. 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.

6. 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 a much lower price. For example, selling the put at $2.50 and buying it back at $0.50

Reasons to be bullish on ARMOUR Residential REIT (NYSE:ARR):

  • A very strong yield of 17.10%
  • A very strong quarterly earnings growth rate of 658%
  • Profit margins of 78%
  • A good free cash flow yield of 14.36%
  • EBITDA increased from -$2million in 2009 to $25 million in 2011
  • Cash flow per share increased from -$0.49 in 2009 to $0.27 in 2011
  • Sales increased from $8million in 2010 to $118 million in 2011
  • A decent current and quick ratio of 1.16 and 1.16, respectively
  • $100K invested since it went public would have grown to $130K. If the dividends were reinvested the rate of return would be higher.

Suggested Strategy for ARMOUR Residential REIT

Click to enlarge

The Jan 2013 7.50 puts are trading in the 1.10-1.30 ranges. There is a pretty decent chance that this stock could test the 6.50 ranges again. If you are willing to wait then you will probably get a better price on these puts. For this example, we will assume that the puts can be sold for 1.20 or better. For each contract sold $120 will be deposited into your account.

Risks

If the stock trades below the strike price (usually on the expiration day of the option), the shares could be assigned to your account. Your final price in this case will be $6.30 (7.50 minus the premium of 1.20). As you were bullish on the stock to begin with this is not a big deal and your actual dividend payment will rise from the current 17% to 19.04%

Advantage

You get the chance to get into the stock at a much lower price and in the process raise your dividend payments. If the stock does not trade below the strike price, you get to walk away with the premium. In this case, you walk away with a gain 18.4% in roughly 7 months.

Company: ARMOUR Residential REIT

Brief Overview

1. Percentage Held by Insiders = 0.59

2. Relative Strength 52 weeks = 56

3. Cash Flow 5-year Average = 0.02

4. Profit Margin = 78%

5. Operating Margin = 78%

6. Quarterly Revenue Growth = 601%

7. Quarterly Earnings Growth = 658%

8. Operating Cash Flow = 250.65M

9. Beta = 0.42

10. Percentage Held by Institutions = 22.6

11. Short Percentage of Float = 8.3%

Growth

1. Net Income ($mil) 12/2011 = -9

2. Net Income ($mil) 12/2010 = 7

3. Net Income ($mil) 12/2009 = -2

4. Net Income Reported Quarterly ($mil) = 24

5. EBITDA ($mil) 12/2011 = 25

6. EBITDA ($mil) 12/2010 = 10

7. EBITDA ($mil) 12/2009 = -2

8. Cash Flow ($/share) 12/2011 = 0.27

9. Cash Flow ($/share) 12/2010 = 0.85

10. Cash Flow ($/share) 12/2009 = -0.49

11. Sales ($mil) 12/2011 = 118

12. Sales ($mil) 12/2010 = 8

13. Sales ($mil) 12/2009 = 0

14. Annual EPS before NRI 12/2010 = 1.12

15. Annual EPS before NRI 12/2011 = -0.15

Dividend history

1. Dividend Yield = 17.10

Important facts investors should be aware in regards to investing and REITS

Payout ratios are not that important when it comes to REITs, as they are required by law to pay a majority of their cash flow as dividends. Payout ratios are calculated by dividing the dividend rate by the net income per share, and this is why the payout ratio for REITS is often higher than 100%. The more important ratio to focus on is the cash flow per share. If one focuses on the cash flow, one will see that in most cases, it exceeds the dividend declared per share.

Conclusion

Only put this strategy to use if you are bullish on the stock, for there is a chance that the shares could be assigned to your account if the stock trades below the strike price. This usually takes place on the expiration day as most option players are in the game to make money trading the option and not to force the seller of the option to purchase the shares.

Note: 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. Options tables sourced from money.msn.com.

Disclaimer: It is imperative that you do your due diligence and then determine if the above strategy meets with your risk tolerance levels. The Latin maxim caveat emptor applies - let the buyer beware.

Source: Armour Residential REIT: Fetch An Additional 17% In Payments Or Get In At A Lower Price