Many times a stock which you're interested in is trading at a small discount to what you consider to be its intrinsic value. When this discount isn't large enough, most people simply wait to see if the stock will decline to a level which they find reasonable. However, another option is to write puts on that stock and essentially get paid for the waiting that you would have done anyways. This allows you to generate a return even before you actually own the stock. Currently, a prime suspect for this type of strategy is Intel (INTC).
Intel currently trades at $26.16 per share. I recently wrote an article on Intel from a dividend perspective and calculated a fair value estimate of $32.60 per share.
As of this writing, Intel trades at $26.16 per share, which is about a 20% discount to my fair value estimate. I like to look for a discount of at least 25%, which represents a share price of $24.45. One option is to submit a limit order and wait for the stock price to drop to my required price, all the while the cash needed for the purchase sits dormant in my account. Or I could get paid to wait for the stock price to drop by writing cash-covered put options with a $24 strike price.
An option has three components: A strike price, a premium, and an expiration date. By selling a put option, you are giving the buyer of that option the right to sell you the underlying stock at the strike price on or before the expiration date. The buyer pays you the premium in exchange for this right. You keep this premium no matter what happens, but are required to buy the stock if the option is exercised.
Selling a cash-covered put option can end in one of two ways. If the stock never dips below $24 per share before the expiration date the option will expire worthless, you will not be required to buy any shares, and you're free to write another put. If, however, the stock does go below $24 per share and the option is exercised, you are required to buy the stock at $24 per share, which will be higher than the current market value.
Let's take a look at the different put options available to sell with a $24 strike price:
|Expiration Date (Days until expiration)||Strike Price||Premium (Last Trade)||Annualized Return|
|Aug 2012 (40)||$24||$0.27||10.27%|
|Sep 2012 (75)||$24||$0.47||9.53%|
|Oct 2012 (103)||$24||$0.64||9.45%|
|Jan 2013 (194)||$24||$1.21||9.49%|
|Apt 2013 (285)||$24||$1.75||9.34%|
The August 2012 expiration date provides the largest annualized return, receiving a $0.27 premium on a $24 investment, resulting in an annualized return of 10.27% (1.125% in 40 days). So if you sell a August 2012 $24 put option you immediately receive a premium of $27 (all options are in blocks of 100 shares) and you have $2,400 tied up for 40 days. If the option expires worthless you can then write another put and collect another premium. If the option is exercised, you will buy 100 shares of Intel for $24 per share, a price which you have already determined is a comfortable entry point.
The downside to this strategy is that if Intel tanks, say to $20 per share, you are forced to pay $24 per share and suffer an immediate "on paper" loss. Of course, had you simply bought shares at the current price or even waited for the price to reach $24 and then bought shares, you would have suffered the same fate. But by selling puts you are able to offset this "on paper" loss with premiums.
By selling Intel puts you are able to generate a 10.27% annualized return on investment as you wait for the stock price to drop to acceptable levels. You should only sell puts on stocks that you would like to own and at strike prices that you are comfortable paying. The worst thing that can happen with this strategy is that you end up with shares of a company that you want to buy at a price which you are willing to pay. Otherwise, you collect a premium and can repeat the process again. It's a win-win for a long-term investor.