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.
Reasons to be bullish on Southern Company (SO):
- A strong relative strength score of 81 out of a possible 100
- Operating cash flow of $5.47 billion
- It is one of the largest electric utility companies in the United States and the top energy firm servicing the Southeast market.
- Management expects to invest $14 billion between 2012 and 2014. The bulk of this capital will be invested in transmission, distribution and generation facilities and this is expected to boost earnings growth through an increase in efficiency and production.
- Southern Company's rate of returns is among the highest in the industry, and it is also a leader in power plant productivity, cost control and new technology research.
- A decent yield of 4.2%
- Five-year sales growth rate of 3.18
- Annual EPS before NRI rose from $2.24 in 2007 to $2.57 in 2011.
- Cash flow increased from $4.62 in 2009 to $5.01 in 2011.
- Net income rose from $1.7 billion to $2.2 billion in 2011.
- A 3-5 year estimated EPS growth rate of 5.04%
- It has consecutively increased its dividend for 11 years in a row.
- Projected year-over-year growth rate of 3.02% and 6.32% in 2012 and 2013 respectively
- A decent interest coverage rate of 3.77
Suggested Put Strategy for Southern Company:
The stock is trading close to its 52-week highs and is rather overbought at this time. From a long-term perspective, it would make sense to wait for a test of the 40-42 ranges before deploying new capital.
The Jan 2014 42 puts are trading in the $2.69-$2.92 ranges. Consider waiting for this stock to pull back to the 44.50-45.50 ranges before putting this strategy to play. These puts should trade in the $3.70-$4.00 ranges if the stock pulls back to the stated ranges. For this example, we will assume that the puts are sold for $3.70.
If the stock trades below the 42, the shares could be assigned to your account. If this comes to pass, it will provide you with the chance of getting into this stock at a much lower price. Your final cost per share will be $38.30. If the shares do not trade below the strike price, you get to walk away with a gain of 8.8%.
If you own the stock, you consider selling some shorter-term covered calls to open up another stream of income. If the stock happens to trade past your strike price, and you do not want to give up your shares (due to capital gains tax, etc.), then all you have to do is roll the call. Buy back the call you sold and sell new out of the money calls.
The only risk factor is that you suddenly change your mind after putting this strategy into play. Perhaps you feel that the stock is going to trade well below the strike you sold the puts at. In this case, you can simply roll the put. Buy back the original put you sold and sell new slightly out of the money puts.
Only implement this strategy if you are bullish on the long-term prospects of this stock, and you are ready for the possibility that the shares could be assigned to your account. In general, selling puts is one of the best ways to get 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 yahoofinance.com
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