The stock is trading at new highs and historically as indicated by the chart below, it has tended to pull back a bit after this event. In the past two years, it has done this several times and it looks like it is getting ready to pull back again. It has fairly strong support in the 30.00-31.50 ranges and could test this zone again before resuming its upward trend. You should be familiar with options before putting this strategy to play.
With this in mind we can put the following strategy into play, which entails selling a covered call and a put. Before we get into the meat of this strategy, we are going to look at some of the benefits associated with selling puts and covered calls.
Benefits of selling covered calls
- Income generation
- Downside protection and reduction in Portfolio volatility
- Predetermined rate of Return
- Converts a common stock into a dividend paying stock
Investors looking for more details on the benefits of selling covered can read our piece on the "Benefits of a Covered Writes Strategy".
Benefits associated with selling naked puts
An investor usually sells a put option if his/her outlook on the underlying security is bullish.
- In essence, you get paid for entering a "limit order" for a stock or stocks you would not mind owning.
- It allows one to generate income in a neutral or rising market.
- 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.
- 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.
- 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.
Suggested Strategy Altria Group Inc (NYSE:MO)
Sell the Jan 2013 34 calls which are trading in the 1.24-1.29 ranges. For this example, we will assume that the calls are sold at 1.24. For each contract, $124 will be deposited into your account. Note that we are selling covered calls and not naked calls, so you need to own this stock in order to be able to put this strategy to use.
Sell the Jan 2013 31 puts for 1.08 or better. They are currently trading in the 1.08-1.12 ranges. For each put sold $108 will be deposited into your account.
This strategy provides you with the chance to collect two premiums in addition to the dividend. One from selling the covered calls and the other from selling puts. Your total gain from both transactions is 6.89% in roughly 7 months. If the stock trades below the strike price the puts were sold at the shares could be assigned to your account. As you were bullish on the stock to begin with this should be not be a big issue especially as get the chance to get in at a lower price. Your final cost will work out to be 29.92 and if you factor in the call premium it drops down to 28.68 (29.92-1.24)
The stock could trade above the price you sold the calls at, and you could end up losing your shares. One simple method to avoid this would be to roll the call if the stock is trading above the strike price.
The other risk factor is that if the stock trades below the strike price you sold the puts; the shares could be assigned to your account. This should not be big deal as one only sells puts when one is bullish on the long-term prospects of the stock. However, if the stock is trading below the strike price you sold the puts at and you have a change of heart, you can also roll the puts and this will remove the chance of the shares being assigned to your account. Shares are usually assigned on the last trading of the option.
This strategy should only be employed by those who are bullish on this stock as there is a chance the shares could be assigned to your account. In addition, there is a chance that you could lose the shares if the stock trades above the price you sold the calls at. You can eliminate this risk by rolling the calls.
The benefit of this strategy is that you open up two new streams of income, and you have the chance of getting into the stock at a lower price. This stock has a low beta which means that it's not very volatile and an ideal candidate to implement this strategy on. Investors looking for other ideas might find this article to be of interest Are These 4 Dividend Plays Worth Getting Into?
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
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: 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.