Philip Morris international (PM) is trading close to its 52-week high. If you look at the two-year chart below, you can see it usually experiences some sort of pullback after trading to new highs. The chart illustrates that Philip Morris has repeated this pattern several times over the past two years, and it looks like it could potentially do so again. It also has fairly strong support in the 80-83 ranges. The following strategy can be put to use to take advantage of this situation. Note that you will need to own the stock, since the first part of the strategy entails selling a covered call. If you do not own the stock, you can implement part two of the strategy.
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Before we get into the meat of this strategy, 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 calls can read our piece on the "Benefits of a Covered Write Strategy".
Benefits of 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 Philip Morris
The Jan 2013, 95 calls are currently trading in the 2.33-2.41 ranges. Sell these calls at $2.33 or better. For this example, we will assume that the calls are sold for $2.33. For each contract sold, $233 will be deposited into your account. We are selling covered calls and not naked calls, so you need to own this stock in order to be able to put this part of the strategy into play. If the stock trades above the strike price, your shares could be called away. If this occurs, you will walk away with a gain of 7.05% (4.80 from the stock and 2.33 from the premium you receive when you sold the calls). If the shares are not called away, your gain will be 2.45%.
Sell the Jan 2013, 80 puts at $2.08 or better. For each put sold, $208 will be deposited into your account. If the stock trades below the strike price the puts were sold at, the shares could be assigned to your account. Your final cost would be $77.92. If the shares are not assigned to your account, you walk away with a gain of roughly 2.6%.
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.
The shares are called away, but the stock does not trade below the price the puts were sold at. In this case, your gain works out to be 9.65% (7.05% plus 2.6%).
The shares are not called away, and the stock does not trade below the strike price the puts were sold at. Your gain in this scenario is 5.05% (2.6% plus 2.45%).
Your shares are called away, and the stock trades below the strike price the puts were sold at. In this case, you get into the stock at 77.92, and you walk away with a gain of 7.05%
Your shares are not called away, but the stock trades below the strike price the puts were sold at. In this case, you get in at a much lower price of 77.92, and also walk away with a small gain of 2.45% from the premium received for the sale of the call.
The stock could trade above the price you sold the calls at. If this happens, your shares could be called away. One simple method to avoid this would be to roll the call if the stock is trading above the strike price and you still want to hold onto the shares.
The other risk factor is that if the stock trades below the strike price you sold the puts at, 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. If you have a change of heart and feel that the stock could trade significantly below the strike price, you can roll the puts. You buy the puts you sold back and sell new puts that are slightly out of the money. 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. Investors looking for other ideas might find this article to be of interest.
Disclaimer: It is imperative that you do your due diligence and then determine if the above strategy fits your risk tolerance levels. The Latin maxim "caveat emptor" (let the buyer beware) applies.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. EPS and Price Vs industry charts, along with a major portion of the historical data used in this article, were obtained from zacks.com. Options tables sourced from money.msn.com.