The strategy we are going to put into play today involves the selling of a covered call, and a naked put. A good time to put the following strategy into play is when a stock is trading in the overbought ranges, and you would not mind banking some of your gains. The covered call gives you the opportunity to close your position out at a predetermined price and also walk away with the premium you received when you sold the call. The premium also serves as a hedge, as it provides you with some downside protection.
The naked put provides you with the option of getting into the stock at a lower price. You usually sell a naked put if you are bullish on the stock, but would like to own the shares at a lower price. With the put you either get in at a price of your choosing, or you at least get paid for trying to. In a way, you are getting put to put in a limit order.
In order to put both parts of this strategy into play you will have to own shares in General Electric Company (GE) as part of the strategy entails the selling of covered calls. However, if you do not own shares in the company and would not mind owning them at a lower price you can put the second part of the strategy into play. In our opinion, the stock is rather overbought, and it would not make sense to purchase shares right now just to be able to sell covered calls. Generally speaking, selling covered calls is a good strategy to employ on dividend-paying stocks that are trading in the overbought ranges. If the shares are called away, you can always redeploy the money into a wide range of great dividend-paying stocks.
Let's quickly examine some of the benefits associated with selling covered calls and naked puts
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 has had a very nice run up over the past two years. It is currently trading at new two-year highs and the charts clearly illustrate that the stock is overbought. The stock also has a tendency to pull back after it has tested the +2SD Bollinger bands on a repeated basis (indicated by the yellow boxes in the above chart). This is especially true if this occurs after a stock has experienced as strong run up. The stock has a decent level of support in the $21 ranges. The markets are in a volatile phase, and a daily close below this will most likely result in a test of the $19.50-$20.00 ranges. This zone offers a much stronger level of support, and investors should consider waiting for the stock to test the $21.00 -$21.50 ranges before selling any puts on this stock. The stock could trade to the $24.00-$25.00 ranges before it starts to correct.
Suggested Strategy for General Electric Company
If the stock trades above the strike price you sold the covered calls at and your shares are called away, you can always deploy the money into other great dividend stocks. Altria Group (MO) and Line Energy (LINE) are two good examples. Altria is a dividend champion that has consecutively increased its dividend for over 46 years. The dividend was recently raised from $0.41 to $0.44 cents. It has a three year dividend growth rate of 8.71%, a five year dividend average of 8.00%, and a current yield of 5.2%. It has a payout ratio of 80% which means it is still taking in more money than its paying out. A payout ratio of over 100% means that the company is paying out more money to shareholders than they are making and vice versa. Out of a possible five stars, we would assign Altria a full five stars in terms of its dividend history. Linn has a five year dividend average of 9.00%, a very good current yield of 7.00% and a very manageable payout ratio of 59%. It increased its distribution payments by over 70% since going public and it has a top notch management in place. Management updated its third quarter and full year guidance. EBITDA guidance was raised from $1.35 billion to $1.36 billion.
The March 2013, 21 puts are trading in the $0.61-$0.63 ranges. If the stock pulls back to the $19.50-$20.00 ranges, these puts should trade in the $1.15-$1.35 ranges. We will assume that the puts can be sold at $1.20 or better.
If the stock trades below the strike price, the puts were sold at, the shares could be assigned to your account. Your final price in this case will be $19.80 per share. If the shares are not assigned to your account, you keep the premium and walk away with a gain of roughly 6.00% in five 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 7.4%
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 roughly five would be 14.8%
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 scenario, you walk away the lowest possible gains, but you get into the stock at a great price of $19.80 per share. You also earn 1.4% from the premium you received when you sold the call. The lower entry price could in the long run lead to much higher rate of return in the form of capital gains than any of the other above two scenarios. Additionally, your yield will rise from 3.0% to 3.4% as a result of the lower entry price.
The stock trades below the strike price the puts were sold at and the shares also trade above the strike price the calls were sold at. In this case, you get into the stock at $19.80, and your shares are called away, and you earn 8.8% in roughly five months. One could also argue that this is probably the best long-term outcome. You get to walk away with a yield that is over six times the yield of the stock (annual basis), your dividend rate moves from 3.00% to 3.4%, and you have the option to capture additional returns via capital gains.
If the stock trades above the price, you sold the calls at, your shares could be called away. This is not really a risk unless you change your mind and decide that you still would like to hold onto these shares. To avoid having your shares called away, you can simply roll the calls. Buy back the calls you sold and sell new out of the money calls.
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. Again, this should not be an issue. You only sell puts if you are bullish on the stock and would not mind owning the shares at a lower price. 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.
The covered calls provide you with an extra stream of income and a predetermined rate of return, if your shares are called away. The puts open an additional stream of income, or they provide you with the opportunity of getting into the stock at a much lower price. If the shares are assigned to your account, not only will you get in at a much better price, but your yield will rise from $3.00% to 3.4%. If you are looking for other ideas, you might find our latest article on SeaDrill (SDRL) to be of interest. The article examines a low-risk strategy that has the potential to yield as much as 66% in roughly six months.
Options tables sourced from yahoofinance.com. Option profit loss chart 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