Oil and gas major BP (NYSE:BP) has been famously apologetic since the Gulf of Mexico disaster, but it really starts to make up for things with its generous dividend - BP currently yields 4.77%. Today we will suggest that income investors can do even better than this yield by writing cash-secured puts.
A put is the right but not the obligation to sell a stock at an agreed upon price until an agreed upon date. The agreed upon price is the "strike" and the date that the rights end is the "expiration." What we are suggesting is that if Jane Doe owns BP's stock for income she would be better served selling another party the right to sell her BP's stock and holding on to her cash in case they decide to. She would be paid a premium for this service she is providing and generally she can create a trade to make that premium larger than the underlying stock's dividend yield.
For example let's say Jane likes BP's stock and thinks it is a good investment while Daniel Day Lewis does not like BP's stock and thinks it is a bad investment. Let's say a share of BP currently trades at $20. Jane can sell Daniel Day Lewis the right to sell Jane a share of BP's stock for $25 until the end of the year. Daniel Day Lewis pays Jane $6 for this service. Jane is happy because BP does not even have to go up and she profits. If BP stays at $20 through the end of the year then Daniel Day Lewis will sell her the share for $25 (this is called being "put the shares") which Jane can turn around and sell for $20 and then repeat the process. How did Jane do? She was paid a $6 premium to buy at $25 and sell at $20, so she nets $1. $1 is 5% of $20 and the trade took 6 months so that comes to about 10% a year. That is a about twice the dividend rate and is not an unrealistic scenario.
Writing cash-secured puts can be a difficult concept to understand so with that in mind we will do a simulation trade wherein we will write a put on BP and compare its performance over time with BP's common stock. Please read the cash secured puts link above. Writing cash-secured puts can have 2 major drawbacks that are critical to understand - liquidity and capping upside - and that article outlines both of them. For an income investor that intends to stay in BP these two drawbacks are greatly minimized. Read the article! : )
In this example the put with the $25 strike had intrinsic value when Jane sold it because it could be executed immediately for a $5 profit. Options with intrinsic value like this are called ITM (in the money). A put with a $15 strike would be OTM (out of the money) by $5. ATM (at the money) means the share price is at or around the strike. You see the acronyms ITM, OTM, and ATM all the time in options discussions.
Options like this also trade in lots of 100. So in the above example if a put costs $6 it really costs $600 and you get the right to sell 100 shares. Prices, however, are usually quoted per share.
The Sound of a Man Working on an Options Chain
Let's check out BP's options chain, a list of the puts and calls (not discussed here) available for BP. (Source ETrade)
BP's stock right now trades for $40.24. Looking at the chain there is a bid for the $46 Jan 19 2013 put for $7.40. If we sell this put for that price and BP neither rises nor falls then we will be put the shares for $46 and can sell them for 40.24. That's $5.76 difference, which is $1.64 less than we were paid for our services.
So let's do it. We will sell this put and receive $740 for it. To "secure" the put we must have enough cash to buy the shares at the strike, in this case 100 shares at $46 each. That's $4,600, minus the $740 that the buyer provides we need $3,860. If we were put the shares now we would profit $164. $164 is 4.25% of $3,860. This trade takes 7 months so its annual return is 7.28%, and that is about one and a half times what the dividend yields us : )
We will name this the "My Left Put" trade (a trade with a good name tends to perform better) and continue to check back and monitor its progress to see how it does compared to BP's stock. Selling puts can be one of the best investment strategies there is, please read the "cash-secured puts" link above to get more detail on the risks and rewards. Here are some other energy names to consider for option trading:
Arch Coal Inc (NYSE:ACI), Alpha Natural Resources, Inc.(NYSE:ANR), Apache Corporation (NYSE:APA), Baker Hughes Incorporated (NYSE:BHI), Peabody Energy Corporation (NYSE:BTU),Chesapeake Energy Corporation(NYSE:CHK),ConocoPhillips(NYSE:COP), Chevron Corporation (NYSE:CVX),Devon Energy Corporation (NYSE:DVN), Enbridge Energy Partners, L.P.(NYSE:EEP), EOG Resources, Inc. (NYSE:EOG), Halliburton Company(NYSE:HAL), Hess Corp.(NYSE:HES), Linn Energy, LLC(NASDAQ:LINE), Marathon Oil Corporation(NYSE:MRO), National-Oilwell Varco, Inc. (NYSE:NOV), Plains All American Pipeline, L.P.(NYSE:PAA),Petroleo Brasileiro SA (ADR) (NYSE:), Penn West Petroleum Ltd (USA)(NYSE:PWE), Royal Dutch Shell plc (ADR)(NYSE:), Seadrill Ltd(NYSE:SDRL), Schlumberger Limited.(NYSE:SLB), Statoil ASA (ADR)(NYSE:STO), Suncor Energy Inc.(NYSE:SU), TOTAL S.A. (ADR)(NYSE:TOT),Valero Energy Corporation (NYSE:VLO), Exxon Mobil Corporation(NYSE:XOM)
Disclosure: I am long ACI.