There are plenty of reasons to sell puts to take bullish positions in stocks, but the fact remains that when you sell a put option, your gain is limited to the premium you collected. In fact, it's always struck me as kind of like buying a bond.
I was thinking about this after I wrote my June 20 article on Walgreen (WAG). In that post I pointed out that the company's annual dividend had been boosted to $1.10 per year - yet the company's stock had been dragged down to around $30 because of plans for Walgreen to buy a stake in Alliance Boots GmbH.
One commenter said he was "tempted" to sell puts on the stock. I was too. So I looked into that as of the open on June 20 -- after my article had posted. With the stock at around $29, one could have sold the January 2013 29-strike put for $2.59.
A 4.16%+ yield if put
Let's say you wanted to sell 10 of these puts on a cash-secured basis. You'd put up $29,000, the amount you'd need to buy 1,000 shares of stock if assigned to you - and collect $2590.
Here's a view of the profit for this position at expiration, a couple of months prior to expiration, and when the position was established.
If the stock were to be put to you, your net cost would be $26,410 ($29,000 minus $2590). That corresponds to the $26.41 level where the red dashed line crosses the 0-profit level. But once the stock is put to you, that $1.10 dividend would deliver a pretty decent 4.16% yield.
If the stock were not put to you, your return would be 8.93% for the $29,000 you kept available 7 months until expiration. Not too shabby either.
But note that you don't really participate in any of the stock's potential upside if it doesn't get assigned to you.
Upside calls to put more lift into your puts
If you think there's potential for some upside, you could devote some of your funds to buying some calls. You collect less upfront, but you can gain if the stock moves higher.
So let's change the scenario. You put up the same $29,000, and sell those same 10 January 29-strike puts for $2590.
But at the same time you buy 4 of the January 31-strike calls for $1.39 each or $556. Now you're collecting only $2034, but that's still 7% of the $29,000 cash securing your short puts.
Here's a look at this position's profitability at various prices and times.
In this case if the stock were put to you, your net cost would be $26,966 ($29,000 minus $2034) so your dividend yield would be a bit less, only 4%.
But you'd also be able to take part in some upside gains if not assigned.
How much upside? Consider if WAG expires at $35. Your 31 strike calls entitle you to pay $12,400 for 400 shares of stock. You've already collected $2034 so your net outlay is $10,366 for 400 shares of stock - or $25.92 per share. That $1.10 would be giving you a 4.2% yield.
Or just sell your calls outright for around $1600 and combine that with the $2034 you collected to buy $3634 worth of the stock for "free." Or you might decide not to buy the stock at all and put the money to work somewhere else.
Selecting the ratio
In this example, I bought 4 out of the money calls. Why not 3 or 5?
There's no one right or wrong approach to this. If you buy more calls, you collect less money upfront, but can take advantage of more upside gains. If you buy fewer calls (or no calls at all), you collect more money up front but limit your upside.
To me Walgreen moving up into the mid 30s by expiration isn't wishful thinking. So if you like the idea of a ratio spread like this one, just play around with the ratio until you find one that seems right to you.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.