The stock looks like it topped out in May as it has put in lower highs since then. Given the strong run-up in the past two years, there is a pretty good chance that this stock could be trading at 80 or below over the next few months before trending higher. We are not bearish on the stock but feel that in the short term, there is a decent chance it could trade down to the 80 ranges. With that in mind let's put the following strategy to work. What we are going to do is sell a put and a covered call (so you need to own the stock to sell calls).
Let's 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. 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.
- Most put options expire worthless and time is on your side. 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 for Philip Morris International Inc (PM):
Sell the Jan 2013 90.0 calls for $2.23 or better. They are currently trading in the 2.23-2.31 ranges. For this example, we will assume that the calls can be sold for 2.23. For each contract sold, $223 will be deposited into your account.
If the stock trades above 90 you shares could be called and you will be paid 90.00 per share. Based on today's price the $6.20 plus the 2.23 premium add up to a gain of 9.9% in roughly 7 months. If you shares are not called, you walk away with a gain of 2.69%.
Sell the Jan 2013, 80 puts for 3.70 or better. They are currently trading in the 3.70-3.80 ranges. For each contract sold, $370 will be deposited into your account. The risk here is that if the stock trades below the strike price, the shares could be assigned to your account. However, your outlook on the stock was bullish as you already owned the shares (you need to own the shares to sell covered calls) so this should not be big issue. Plus you get the chance to get in at a much lower price. If the shares are assigned to your account, your final price will be 76.30.
If the shares are not assigned to your account, then you get to keep the premium for a gain of 4.62% in roughly seven months.
You would earn the most if your shares are called away, but the stock does not trade below the price you sold the puts at. In this scenario, you stand to make 14.5% (9.9% plus 4.62%). If the stock trades below the price you sold the puts at the stock could be assigned to your account.
If the shares are not called away and neither are they assigned to your account, then you make 2.69% from the covered call portion and 4.62% from the sale of the puts, for a total gain of 7.31% in 7 months.
If the shares are called, and the stock is assigned to your account because it traded below the strike price you sold the puts at, then you make 9.9% and your back in at 76.30 (80-3.70).
Finally, if the shares are not called, but the stock is assigned to your account, then you make 2.69% from the covered calls you sold, and you purchase additional shares at 76.30 (80.00-3.70).
Disclaimer: 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