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
- 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.
- 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 your returns over time.
- 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. 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.
- 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.
Reasons to be bullish on Philip Morris (PM):
- It has very strong levered free cash flow of $9.0 billion.
- A quarterly earnings growth rate of 12.6%
- A strong relative strength score of 86 out of a possible 100
- A quarterly revenue growth rate of 9.7%
- Annual EPS before NRI increased from $2.80 in 2007 to $4.88 in 2011.
- A good payout ratio of 59%
- A projected 3-5 year EPS growth rate of 9.33%
- A very strong Interest coverage rate of 15.9
- A decent yield of 3.7%
- Net income has surged from $6.3 billion in 2009 to $8.5 billion in 2011, an increase of over 36%
- Cash flow per share has increased from $3.83 in 2009 to $5.55 in 2011, an increase of 44%
- It sports a decent five-year dividend of 4.26%
- It has a good free cash flow yield of almost 6.00%
- It reported diluted EPS of $4.85 in 2011 compared to $3.92 in 2010, an increase of 23.7%
- It exceeded its one year gross productivity and savings target of $250 million
- Free cash flow increased by 10.4% to 9.6 billion in 2011
- It increased its quarterly dividend during the year by 20%; the annual rate now stands at $3.08
- It repurchased 80.5 million shares of common stock in 2011 for $5.4 billion
- Projected year over year growth rate of 7.07% and 10.64% for 2012 and 2013 respectively
First quarter 2012 highlights.
- It reported adjusted diluted earnings of $1.25 per shares, an increase of 17.9% vs. 1.06 in 2011
- Shipment volume of cigarettes increased by 5.4%
- Revenues rose by 9.7% to $7.4 billion
- Operating income rose by 13.2% to $3.4 billion
- 18.1 million Shares were repurchased for $1.5 billion
- Management revised its 2012 forecast of diluted earnings per share in the range of $5.20-$5.30 vs. $4.85 in 2011. These forecasts are based on the current exchange rates
- $100K invested science its inception would have grown to $183k. If the dividends were reinvested the rate of return would have been higher
Suggested put strategy for Philip Morris:
The stock has had a very nice run in the past two years as indicated by the chart below. The run up in May to new highs did not take place on high volume. In fact, the volume seemed to increase on the way down after it topped out in May. Overall the volume was good, so this is a short term negative factor and suggests that this stock is still consolidating. Potentially this stock could trade down to the 80 ranges. If you already have a position in this stock, then consider waiting for a test of the 80 ranges before putting this strategy into play.
If you wait for the stock to trade down to the 80 ranges, then the Jan 2013, 80 puts should roughly trade in the 5.60-5.80 ranges. For this example, we will assume that each put is sold for $5.60 when and if the stock trades down to the suggested ranges. For each contract sold, $560 will be deposited into your account.
Advantages of this strategy
You have the opportunity of getting into the stock at much lower price if the shares are assigned to your account. If the shares are assigned to your account, your final cost per share will be 74.40. If the shares are not assigned to your account, you get to walk away with a gain of 7% in roughly 7 months.
Unless you have had a change of heart, the risk factor is that the shares are assigned to your account. However, as you were bullish when you initiated the strategy and were ready for this possibility, it should not be a big deal. The only risk is that you have a change of heart after implementing this strategy. For example, the stock is trading at a lower price than you expected and you now feel that it could trade well below the strike price you sold the puts at. In this case, the remedy is simple, you just roll the puts. In other words, buy the original puts back and sell new out of the money puts.
For investors looking for other ideas detailed data has been provided on two additional companies. Our latest article could also prove to be a source of new ideas Deere & Co: An Extra 9.2% In 7 Months Or Jump In At 65.80.
Company: BHP Billiton Ltd (BHP)
- Long term debt to equity ratio = 0.23
- Short ratio = 3.8%
- Quarterly earnings growth = -5.00%
- Quarterly revenue growth = 9.9%
- Profit Margins = 30.5%
- Beta = 1.79
- Operating cash flow = $30.17B
- Levered free cash flow = $14.22B
- Net Income ($mil) 12/2011 = 23946
- Net Income ($mil) 12/2010 = 13009
- Net Income ($mil) 12/2009 = 5877
- EBITDA ($mil) 12/2011 = 36784
- EBITDA ($mil) 12/2010 = 24331
- EBITDA ($mil) 12/2009 = 15488
- Cash Flow ($/share) 12/2011 = 16.64
- Cash Flow ($/share) 12/2010 = 10.26
- Cash Flow ($/share) 12/2009 = 6.08
- Sales ($mil) 12/2011 = 71739
- Sales ($mil) 12/2010 = 52798
- Sales ($mil) 12/2009 = 50211
- Annual EPS before NRI 12/2007 = 2.24
- Annual EPS before NRI 12/2008 = 5.5
- Annual EPS before NRI 12/2009 = 2.1
- Annual EPS before NRI 12/2010 = 4.48
- Annual EPS before NRI 12/2011 = 7.83
- Dividend Yield = 3.6
- Dividend Yield 5 Year Average = 2.25
- Dividend 5 year Growth = 25.9
- Next 3-5 Year Estimate EPS Growth rate = 11.92
- Debt/Total Cap 5 Year Average = 14.12
- Current Ratio = 0.9
- Current Ratio 5 Year Average = 1.53
- Quick Ratio = 0.60
- Cash Ratio = 0.55
- 5 year capital spending growth rate = 20.31%
- EPS 5 year growth rate = 11.47%
- 5 year sales growth rate = 14.42%
Company: American Capital Agency (AGNC)
- Relative Strength 52 weeks = 74
- Cash Flow 5-year Average = 3.36
- Short ratio = 1.3%
- Quarterly earnings growth = 378%
- Quarterly revenue growth = 362%
- Profit Margins = 92.8
- Beta = 0.2
- Operating cash flow = $1.36 B
- Net Income ($mil) 12/2011 = 770
- Net Income ($mil) 12/2010 = 288
- Net Income ($mil) 12/2009 = 119
- Cash Flow ($/share) 12/2011 = 5.18
- Cash Flow ($/share) 12/2010 = 4.13
- Cash Flow ($/share) 12/2009 = 5.22
- Sales ($mil) 12/2011 = 1135
- Sales ($mil) 12/2010 = 383
- Sales ($mil) 12/2009 = 174
- Annual EPS before NRI 12/2009 = 5.17
- Annual EPS before NRI 12/2010 = 4.39
- Annual EPS before NRI 12/2011 = 5.21
- Dividend Yield = 15.4
- Dividend 5 year Growth = 35.61
- Payout Ratio = 0.87
- Payout Ratio 5 Year Average = 1.17
- Next 3-5 Year Estimate EPS Growth rate = 2
- 5 Year History EPS Growth = 6.52
- ROE 5 Year Average = 18.35
- Current Ratio = 0.1
- Current Ratio 5 Year Average = 0.06
- Quick Ratio = 0.06
- Interest Coverage = 4.60
Selling puts is a great way to get into a stock you like at a price of your choosing. Your final price is a lot lower than the strike price you sold the puts at because you get to apply the premium towards your purchase. If the shares are not assigned to your account, you get to walk away with the premium. In this case, it's a gain of 7% in seven months. If your outlook on this stock is not bullish, then you would be better off looking for other plays. Investors looking for other ideas might find this article to be of interest - Corning Inc: 3-1 Leverage With No Out Of Pocket Cost.
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.