The strategy of selling a put to purchase calls provides you with the opportunity to leverage your position in American Capital Agency Corp. (NASDAQ:AGNC), and the chance to get into the stock at a much lower price. Only put this strategy to use if you are bullish on the prospects of this stock as there is a chance that the shares could be put to your account. If you are not bullish on the stock, then it would be in your best interest to look for alternative plays.
Suggested strategy for American Capital Agency Corp.
The stock has been in a strong uptrend for the past 3 years. Any negative new seems to be a short-lived event. In terms of performance, it is one of the top performing REITs, significantly outperforming plays such as Armour Residential REIT (NYSE:ARR), Capstead Mortgage Corp (NYSE:CMO), Invesco Mortgage Capital (NYSE:IVR) and even Annaly Management (NYSE:NLY) over a three-year period (look at above chart).
The flash crash on the 7th of August proved to be yet another buying opportunity, as has been the case on at least two other occasions in the past two years. In all three instances, the stock recovered and soared to new highs in a relatively short period of time. The stock is overbought, but is in a strong uptrend and looks set to put in a series of new 52-week highs before pulling back. If you have patience, consider waiting for a test of $33 before putting this strategy into play. If it pulls back to the $33 ranges, you will receive a higher premium for your puts and be in a position to pay even less for the calls you purchase.
This play has two parts to it. The first part entails selling a put and in the second part calls are purchased with the proceeds from part 1.
The Jan 2013, 33.00 puts are trading in the $1.46-$1.70 ranges. We will take the midway point and assume the puts can be sold at $1.55 or better. For each contract sold $155 will be deposited into your account. The proceeds from the sales of the puts will be used to complete the second part of the trade.
The Jan 2013, 36 calls are trading in the $0.33-$0.38 ranges. If you work the option, it is possible that you could purchase these calls at a better price than $0.38. However, for this example we will assume that the calls are purchased at $0.38. For each put sold you will be able to purchase up to 4 calls. If you are looking for even more leverage, you could aim for the Jan 2013, 37 calls, which are currently trading in the $0.12-$0.23 ranges.
Benefits and risks associated with this strategy
You have an opportunity to significantly leverage your position in this stock for a relatively low cost. You would only need to put up $3300 to secure the put, but you would be in a position to control up to 400 shares. If you had to purchase 400 shares at the current price, you would have to put up roughly $14,200.
If the stock trades below the strike price you sold the puts at, the shares could be assigned to your account (assignment usually occurs on the last trading day of the option). Depending on the number of calls you purchased your cost per share could range from $31.83 (if you purchased one call only) to $32.92 (if you purchased four calls). As long as you are bullish on the stock, the possibility of having the shares assigned to your account should not be an issue, as this strategy provides you with the chance to get into this stock at a lower price.
The only real risk is that you have a change of heart and are no longer bullish on the prospects of the stock. In this case, you can roll the put. Buy back the old puts and sell new out of the money puts.
While the trend is still up the markets are in a volatile phase. Consider closing half the position out if the calls are showing gains in the 60%-100% ranges.
Options tables sourced from yahoofinance.com. Option Profit loss graph sourced from poweropt.com. Earnings vs expectations data sourced from smartmoney.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.
Business relationship 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.