Selling put options is a great way to put idle cash to work. You collect the option premium should the stock stay above the strike price at expiration. In my previous article, I discussed 3 put option candidates in the Consumer Goods sector to sell:
- Procter & Gamble (PG) - Sell the July 62.50 Put for 1.46 or better
- Kellogg Company (K) - Sell the September 50.00 Put for 2.05 or better
- Clorox (CLX) - Sell the July 65.00 Put for 1.10 or better
At the time of writing my previous article, I sold the June 62.50 Put for PG on May 14 for 0.66. PG closed on June 15 at $62.88, just a hair above the strike price. However, just a few days later, PG lowered its Q4 2011 guidance, sending the stock tumbling towards $60.
In a way, I was fortunate. Since I already have some capital committed to PG at the time, I did not want to overweight PG by selling the July 62.50 Put before my June 62.50 Put expires. But what if I actually followed my own advice and sold the July 62.50 Put for 1.46? Well, I would be underwater, of course. Below is the option quote on the close of June 22:
Given the entry price of 1.46, buying back the option to close would cost 3.20, giving me a loss of 1.74, or $174 per contract I sell (less commission). But this loss can be remedied in a few ways. I will list them out below.
Wait and See
As of this writing, the July 62.50 Put still has around 0.48 of time value left. By waiting out a few more weeks, you can eventually "collect" this amount. Assuming that the price for PG does not change too much from the current price, you can pay less money to buy back to close the put option. In fact, if the price for PG were to go up to 61.46 before July 20 (a 2.7% increase from the closing price of 59.83), you would be able to close out your position for little or no loss.
Give it to Me
Okay, this is not really a remedy. But if you really don't care what price Mr. Market gives to PG, and you are happy to own PG at the break-even/entry price of 61.46, just go out and enjoy your summer. PG is a great long-term investment, and if anything, the recent sell-off will simply be a bump in the road. In fact, once you have been "put" the stock (or even before that), you can turn around and sell covered calls to collect some premium in addition to the dividend.
You can buy back the put option you sold and roll the position forward. This will allow you to earn more time value, which effectively reduces your net entry price. Below are various 62.50 Put options with different expiration dates.
Effectively, you can still collect 0.20, 0.95, 1.85, and 5.05 more if you buy back the July 2012 put and sell the August 2012, October 2012, January 2013 and January 2014 puts. Personally, I would not roll forward too many months in advance, even though the premium you can collect is potentially very large. The fewer months you roll forward, the more flexibility you give yourself if there is a sudden move in PG's stock price.
As an example, rolling forward to October 2012 will allow you to collect 0.95, or $95 more per contract. This allows you to lower your entry price to 60.51, and gives you a few more months of time. You can repeat this again once the November 2012 or December 2012 options become available to further reduce your entry price.
Roll Forward and Down
If somehow you came to the realization that the effective entry price of 61.46 is NOT the price you want to own PG at, then you can proceed to roll forward and roll down in strike price. The goal is to roll down a strike a few months out at no loss (because losing when you don't have to is annoying). Our goal is to find a lower strike price that can be sold for 1.74 or better (remember that the loss I would be facing is 1.74). Below is the list of available put options:
You can roll down to 60.00 by October 2012, 57.50 by January 2013, and all the way down to 45.00 by January 2014. As tempting as it is to roll down to 45.00, you will be effectively locking your money in for the next 1.5 years all for a measly $4 per contract.
I would personally roll down to 57.50 January 2013 Put option. This leaves you with $66 in premium collected, which is around 2% annualized. This will also free up $500 of cash per contract, so you can sell put options for other stocks, perhaps speculative ones such as Nokia (NOK) or Frontier Communications (FTR).
Sell More Puts
If you want to be more aggressive, or feel that the recent drop-off in price is unwarranted, you can sell more put options on PG while employing any one of the strategies above on your existing position. By selling more put options at a lower strike price, this allows you to scale in to more positions at lower entry prices, should the price of PG continue to drop. Of course, if the price of PG stabilizes, then the additional puts you sell will expire worthless, and you can use the collected premium to further lower the entry price of your initial trade.
Having a bad put trade is not the end of the world. This is especially true if the underlying stock is a quality stock like PG that you don't mind owning on the dip. Selling put options and having enough capital to own the stock gives you many flexibilities to remedy a bad trade.