Selling naked puts is a great way to purchase shares in companies you like at a predetermined price. In essence, you are getting paid to put in a "limit order."
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.
Some fundamental reasons to like VIVUS
According to Bloomberg, 42% of Americans will be obese by 2030. This is certainly good news for both Vivus (VVUS) and Arena (ARNA) as they both received approval to market their respective anti-obesity drugs.
However, it appears that Vivus' drug will hit the market earlier, even though Arena received approval first. Qsymia is expected to be available by the end of 2012. According to Rodham & Renshaw, sales for Qsymia could hit $42 million this year and $290 million by next year. Even if they fail to hit this mark, the company will certainly experience a surge in earnings next year.
Clinical trials showed that Qsymia was more effective than Arena's Belviq. Patients who took Qsymia on average lost 10% of their body weight as opposed to 4% for those who took Belvig. Additionally, Vivus received approval for a secondary drug called Stendra for the treatment of erectile dysfunction. Thus, unlike Arena it's not completely reliant on the success of its Anti-obesity drug. According to Bloomberg, Stendra works in less than half the time it takes Viagra to work. Potentially, Stendra could give Pfizer's (PFE) Viagra a run for their money.
Suggested strategy for VIVUS Inc.
The stock is currently correcting after experiencing a strong run up. It has pretty good support in the 19.50-20.00 ranges, but could potentially drop down to the 18.50 ranges on an intraday basis. The stock is now trading 1 standard deviation below the 30 day Bollinger band. The last 2 times this occurred (indicated by the blue boxes), it reversed course pretty quickly. As it is trading below this level again the odds favor that it will be trending above the 30 day Bollinger band in the not too distant future. Given the strong run it is likely to test its recent lows one more time before trending upwards. We would wait for a test of the 19.00-19.50 before putting this strategy into play.
The January 2013 19 puts are trading in the 2.27-2.37 ranges. If the stock pulls back to the stated ranges, the puts should trade in the 3.10-3.30 ranges. For this example, we will assume that the puts can be sold for $3.10 or better. For each contract sold, $310 will be deposited into your account.
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 $15.90. If the shares are not assigned to your account, you will walk away with a gain of 18.8% in less than 6 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 $15.90
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.
This is a volatile stock, so only those investors willing to take on some extra risk should consider putting this strategy to use.
EPS, company vs. industry 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. Option Profit loss graph sourced from poweropt.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.