In order to put both parts of this strategy into play you will have to own shares in SeaDrill Limited (NYSE:SDRL) as we are going to be selling covered calls and puts. The stock is overbought in the short to mid-term time frames and could trade down to the $36 ranges. Note that we are not bearish on the long-term prospects of this company. Selling covered calls is a good strategy to implement on dividend-paying stocks when they are trading in the overbought ranges. Additionally, we are going to sell puts with the intent of trying to get into this stock at a lower price.
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.
The stock is overbought and is set to run into pretty strong resistance in the $42.00-$42.30 ranges. If it trades to these ranges and fails to hold, it will put in a double top formation. Double top formations in general are bearish formations. Note that the RSI and stochastics are also trading in overbought ranges. Additionally, the stock is trading above the + 1 standard deviation mark, and stocks generally have a tendency to pull back after this occurs. Finally, crude oil appears to have topped out, and this stock has a tendency to trend in the same direction.
Suggested Strategy for SeaDrill Limited
The Jan 2013, $42.85 are trading in the $1.25-$1.40 ranges. For this example, we will assume that the calls can be sold at $1.30 or better. If your shares are called away you will walk away with a net gain of 7.7% in less than six months. If your shares are not called away, you will walk away with an extra 3.16% in addition to the dividend payments you will receive.
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.
The Jan 2013, $35.85 puts are trading in the $1.40-$1.55 ranges. We will assume that the puts can be sold at $1.45 or better. If the shares trade below the strike price you sold the puts at, the shares could be assigned to your account. Your cost per share in this case will be $34.40. If the shares are not assigned to your account, you get to walk away with a 4.2% in less than six months.
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 7.36%.
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 11.9%.
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 $34.40, and you earn roughly 3.16%.
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 $34.40, your shares are called away, and you earn roughly 7.7%.
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 a 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.
Selling covered calls provides you with an extra stream of income and a predetermined rate of return, if your shares are called away. The puts provide you with another source of income or the chance to get into this stock at a price of your choosing. It is generally a great strategy to implement on stocks that are overbought.
Options tables sourced from Yahoo Finance.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. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article was prepared for Tactical Investor by one of our analysts. We have not received any compensation for expressing the recommendations in this article. We have no business relationships with any of the companies mentioned in this article.