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.
- 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.
Wells Fargo (NYSE:WFC) has been trending upwards nicely since Dec, 2011. However, the markets are still consolidating, and a normal correction usually ends with a retest of the lows on lower volume. It also faces a decent amount of resistance in the 34.00-34.50 ranges. Thus, there is a decent chance that it could test its recent lows in the 29.00-30.00 ranges before trending higher.
Suggested Put strategy for Wells Fargo
We would wait for it to trade down to the 30.50-31.00 ranges before putting this strategy into play. The Jan 2013 30 puts are trading in the 2.13-2.17 ranges. If the stock pulls back to the stated ranges, then these puts should trade in the 2.90-3.20 ranges. For this example, we will assume that the puts can be sold at 2.95 if the stock trades in the suggested ranges. For each contract sold, $290 will be deposited into your account.
If the stock trades below the strike price, the shares could be assigned to your account. In this case, your final price will be $27.05 per share. If, on the other hand, the stock does not trade below the strike price, you walk away with a gain of 9.83% in seven months.
As you were bullish from the onset, the only risk factor is that you have a change of heart after implementing this strategy. Perhaps the stock is trading at a lower price than you expected, and you now feel it could go drop even more. In this case, you simply roll the put. You purchase the puts back and sell new puts that are slightly out of the money. Note that in the above example you break even point is $27.05.
Company: Wells Fargo & Co
Basic Key ratios
- Percentage Held by Insiders = 0.05
- Percentage held by institutions = 77%
- Short ratio = 1.00%
- Quarterly earnings growth = 13%
- Quarterly revenue growth = 8.4
- Beta = 1.10
- Relative Strength 52 weeks = 81
- Cash Flow 5 -year Average = 2.63
- Operating cash flow = $12.6B
- Dividend Yield 5-Year Average = 2.56
- 5 year sales growth rate = 17.36%
- Net Income ($mil) 12/2011 = 16211
- Net Income ($mil) 12/2010 = 12663
- Net Income ($mil) 12/2009 = 12667
- EBITDA ($mil) 12/2011 = 30238
- EBITDA ($mil) 12/2010 = 26132
- EBITDA ($mil) 12/2009 = 27015
- Cash Flow ($/share) 12/2011 = 3.43
- Cash Flow ($/share) 12/2010 = 2.77
- Cash Flow ($/share) 12/2009 = 3.01
- Sales ($mil) 12/2011 = 87597
- Sales ($mil) 12/2010 = 93249
- Sales ($mil) 12/2009 = 98636
- Annual EPS before NRI 12/2007 = 2.38
- Annual EPS before NRI 12/2008 = 0.75
- Annual EPS before NRI 12/2009 = 1.81
- Annual EPS before NRI 12/2010 = 2.26
- Annual EPS before NRI 12/2011 = 2.82
- Dividend Yield = 2.7
- Dividend Yield 5 Year Average = 2.4
- Dividend 5 year Growth = - 7.31%
- Payout Ratio = 0.20
- Payout Ratio 5 Year Average = 0.41
- Next 3-5 Year Estimate EPS Growth rate = 10.09
- 5 Year History EPS Growth = 5.96
- ROE 5 Year Average = 12.58
- Return on Investment = 5.98
- Current Ratio = 0.9
- Current Ratio 5 Year Average = 0.97
- Quick Ratio = 0.85
- Cash Ratio = 0.14
- Interest Coverage = 5.00
- Retention rate = 80%
Selling puts is generally a good way of getting into a stock you like at a price of your choosing. If the shares are not assigned to your account, you at least get paid for trying. In this case, you stand to make an extra 9.8% in roughly seven months. Investors looking for other ideas might find this article to be of interest - An Interesting Array Of Dividend Plays To Consider for your portfolio.
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.
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.