In order to put both parts of this strategy into play you will have to own the stock as part of the strategy entails the selling of covered calls.
Before we get into the meat of this strategy, we are going to 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 can read our piece on the "Benefits of a Covered Writes Strategy".
Benefits associated with 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 for American Capital Agency (AGNC)
It has tried to break past 35 three times in the month of July and so far each attempt has failed. One could argue that it is putting in a short term triple top formation. These formations very often lead to pretty strong pullbacks.
The Jan 2013, 36 calls are trading in the $0.54-$0.62 ranges. We would wait for a spike above 35.00 before selling these calls. If the stock trades to the 35.00-35.50 ranges it should be relatively easy to sell these calls for $0.65 or better. For this example we will assume that the calls are sold at $0.65. For each contract sold, $65 will be deposited into your account. If the stock trades above the strike price, your shares could be called away and you would walk away with a gain of 4.58%. If they are not called away you get to keep the premium for a gain of roughly 1.8%
If you do not want your shares to be called because you are sitting on significant capital gains, then you can roll the call. Buy back the calls you sold and sell new out of the money calls with a little extra time on them. This process nearly always allows you to walk away with a net credit if implemented in time. In other words, if the stock is trending upwards do not wait till the calls are deep in the money before you decide to roll them. If implemented properly you could keep rolling the calls to avoid having your shares called away.
The Jan 2013, 30 puts are trading in the $0.84-0.95 ranges. For this example we will assume that the puts can be sold for $0.90 based on the last transaction. For each put sold, $90 will be deposited into your account. If the stock trades below the strike price, the shares could be put to you. Your final price in this case would be $29.10. If the shares do not trade below the strike price you get to keep the premium for a gain of roughly 3%.
Possible Outcomes of this strategy
The stock does not trade above the strike price the calls were sold at, nor does it trade below the strike the puts were sold at. In this case, you walk away with a gain of 4.8% (1.8 +3.00)
The stock trades above the strike price the calls were sold at but not below the strike price the puts were sold at. In this case, you walk away with the highest gains, but you also lose your shares. The total return here for seven months would be 7.58% (4.58+ 3.00)
The stock trades below the strike price the puts were sold at but not above the strike price the calls were sold at. In this case you get into the stock at a lower price of 29.10 and you earn roughly 1.8%.
The stock trades below the strike price the puts were sold at but the shares also trade above the strike price the calls were sold at. In this case you get into the stock at $29.10, your shares are called away and you earn roughly 4.58%
Benefits of this strategy
The benefit from this strategy is that you now have the chance to open two extra streams of income, in addition to the dividend. You also have the chance to get into the stock at a lower price if the stock trades below the strike price the puts were sold at.
The stock could trade above the price you sold the calls at, and you could end up losing your shares. One simple method to avoid this would be to roll the call if the stock is trading above the strike price you sold the calls at.
The other risk factor is that the stock trades below the strike price you sold the puts, and the shares are 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 the shares are assigned to your account, you get the chance to get in at a much lower price. If you have a change of heart after selling the puts because you now feel that the stock could trade significantly below the strike price, then you can roll the puts. Buy back the old puts and sell new slightly out of the money puts with more time on them.
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
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.