Selling naked puts is a great way to purchase shares in companies you like at a predetermined price.
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 the Jan 2013, 37.85 Seadrill (NYSE:SDRL) puts for $2.35. $235 per contract sold would be deposited in your account, which could be applied to the purchase price if the shares were assigned to 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 Wells Fargo (NYSE:WFC)
The stock has a nice run up over the past 7 months and as of late has been generating several negative divergences. In this case, the negative divergence has arisen because its recent highs have not been validated by several key technical indciators. This suggests that the stock is ripe for a correction, and it could trade down to the 29.00-30.00 ranges. Additionally, the stock is rather overbought so it would make sense to wait for a pullback before jumping in.
In our opinion, the risk to reward ratio would move in our favor if we wait for the stock to pull back before selling puts. We could miss out on this play, but then there are many other plays out there, and in general, it never pays to chase a stock.
The stock has pretty strong support in the 30 ranges. We would wait for a test of the 30.00-30.50 ranges before putting this strategy to use. The Jan 2013, 32 puts are trading in the $1.53-$1.55 ranges. The stock is currently trading at 34.00. A pullback to the suggested ranges should push the price to the $3.30-3.50 ranges. We selected these puts as there is a better chance of having the shares assigned to your account when the puts are in the money. For this example, we will assume that the puts can be sold for $3.30. If you prefer to sell out of the money puts, you could sell the Jan 2013, 30 puts. The Jan 2013, 30 puts should trade in the $1.80-$1.90 ranges if the stock pulls back to the suggested ranges.
Benefits of This Strategy
If the stock trades below the strike price, the shares could be assigned to your account. If this occurs, you have the opportunity of getting into a stock you like at a much lower price. Your final price when the premium is factored in will work out to $28.70. If the shares are not assigned to your account, you will walk away with a gain of 11.5% in six months.
Your Potential Risk
As long as you are bullish on the stock and are open to the possibility that the shares could be assigned to your account, your risk is limited. Essentially you are taking on the same level of risk as you would if you bought the shares outright, but with the added benefit of getting in at a lower price (via the premium you received). When you put in a limit order, it is either filled or not. If it's not filled you do not get paid for trying.
As a reminder only put this strategy into play if you are bullish on the stock and prepared for the shares to be put to your account. 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. Your breakeven point in this trade is $28.70.
A Suggestion to Boost Your Potential Gains
Take some of the premium you received from the puts you sold to purchase some out of the money calls when and if the stock trades to the suggested ranges. If the stock should subsequently take off, you could walk away with some rather handsome gains.
Company: Wells Fargo & Co
Basic Key ratios
- Percentage held by institutions = 77%
- Short ratio = 1.8%
- 52 week change = 48%
- Profit margins = 22.5%
- Quarterly earnings growth = 5.10%
- Quarterly revenue growth = 17%
- Beta = 1.16
- Relative Strength 52 weeks = 81
- 5 year sales growth rate = 13.56%
- EPS vs 1 year ago = 17.1%
- Sales vs 1 year ago = -6%
- Net Income ($mil) 12/2011 = 16211
- Net Income ($mil) 12/2010 = 12663
- Net Income ($mil) 12/2009 = 12667
- EBITDA ($mil) 12/2011 = 30238
- EBITDA ($mil) 12/2010 = 26132
- EBITDA ($mil) 12/2009 = 27015
- Cash Flow ($/share) 12/2011 = 3.43
- Cash Flow ($/share) 12/2010 = 2.77
- Cash Flow ($/share) 12/2009 = 3.01
- Sales ($mil) 12/2011 = 87597
- Sales ($mil) 12/2010 = 93249
- Sales ($mil) 12/2009 = 98636
- Annual EPS before NRI 12/2007 = 2.38
- Annual EPS before NRI 12/2008 = 0.75
- Annual EPS before NRI 12/2009 = 1.81
- Annual EPS before NRI 12/2010 = 2.26
- Annual EPS before NRI 12/2011 = 2.82
- Dividend Yield = 2.6
- Dividend Yield 5 Year Average = 2.4
- Dividend 5 year Growth = - 20.5%
- Payout Ratio = 0.23
- Payout Ratio 5 Year Average = 0.41
- Next 3-5 Year Estimate EPS Growth rate = 10.09
- 5 Year History EPS Growth = 5.96
- ROE 5 Year Average = 12.58
- Return on Investment = 5.98
- Current Ratio = 0.9
- Current Ratio 5 Year Average = 0.97
- Quick Ratio = 0.85
- Cash Ratio = 0.14
- Interest Coverage = 5.00
- Retention rate = 77%
This strategy should only be implemented if you are bullish on the stock as there is a chance that the shares could be assigned to your account. The benefit of this strategy is that it provides you with the opportunity of getting into a stock you like at a price of your choosing or getting paid for your efforts.
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. Earnings vs estimates and growth rates sourced from smartmoney.com. Option profit and loss graph sourced from poweropt.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.