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.
- 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 Put Strategy for Exelon Corp (EXC)
It has tested the $36.00 ranges twice, once in June ($36.34) and once in July (36.27). After a long correction, it is generally a more bullish sign when a stock puts in higher lows. In this case, it has put in lower lows so there is still a chance that it could spike below $36.00 on an intra day basis. The stock has taken a serious drubbing, and it appears to be trying to put in a bottom. A weekly close above $39 will turn the outlook to bullish. If you are bullish on the long-term prospects of this stock, you can implement the following strategy.
We would wait for the stock to pull back to the $36.50-$37.00 ranges and then attempt to the sell the Jan 2013, 37 puts. These options are currently trading in the $1.85- $2.05 ranges. A pullback to the stated ranges should drive the price of these options to the $2.05-$2.30 ranges. For this example, we will assume that we can sell these puts for $2.10 or better. $210 will be deposited into your account for each contract sold.
If the stock trades below the strike price, the shares could be put to you (assigned to your account). If this is the case, you have the opportunity of getting into this stock at a much lower price. Your final price per share will be $34.90 ($37.00 minus $2.10). If the stock is not assigned to your account, you walk away with a gain of 5.6% in roughly 7 months. This is basically equivalent to its current annual yield.
Your Potential Risk
The only risk factor here is that you have a change of heart after selling the puts. Perhaps you now feel that the stock could trade well below the strike price. In this case, the solution is to roll the put. Purchase the put you sold back and sell new slightly out of the money puts. Your break-even point in this trade is $34.90.
Company: Exelon Corp
- Relative Strength 52 weeks = 55
- Cash Flow 5 -year Average = 7.72
- Quarterly revenue growth = -5.40%
- Quarterly earnings growth = - 70%
- Profit margins = 10.87%
- Net Income ($mil) 12/2011 = 2495
- Net Income ($mil) 12/2010 = 2563
- Net Income ($mil) 12/2009 = 2707
- EBITDA ($mil) 12/2011 = 6982
- EBITDA ($mil) 12/2010 = 7981
- EBITDA ($mil) 12/2009 = 7751
- Cash Flow ($/share) 12/2011 = 7.64
- Cash Flow ($/share) 12/2010 = 8.42
- Cash Flow ($/share) 12/2009 = 8.07
- Sales ($mil) 12/2011 = 19184
- Sales ($mil) 12/2010 = 18644
- Sales ($mil) 12/2009 = 17318
- Annual EPS before NRI 12/2007 = 4.31
- Annual EPS before NRI 12/2008 = 4.17
- Annual EPS before NRI 12/2009 = 4.12
- Annual EPS before NRI 12/2010 = 3.95
- Annual EPS before NRI 12/2011 = 4.16
- Dividend Yield = 5.6
- Dividend Yield 5 Year Average = 4.00
- Dividend 5 year Growth = 4.96
- Payout Ratio = 0.74
- Payout Ratio 5 Year Average = 0.49
- ROE 5 Year Average = 23.37
- Current Ratio = 1.30
- Current Ratio 5 Year Average = 1.2
- Quick Ratio = 0.60
- Cash Ratio = 0.4
- Interest Coverage = 82.9
Only implement this strategy if you are bullish on the stock, and you are ready for the possibility that the shares could be put to you. Selling puts is one of the better methods of getting into a stock you are bullish on. You either get in at a lower price, or you get paid for trying to.
EPS and Price vs industry charts obtained from zacks.com. A major portion of the historical/research data used in this article was obtained from zacks.com. Options tables sourced from money.msn.com.
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.