We are going cover a low-risk strategy today that entails the selling of a covered call, and a naked put. The best time to put this strategy into play is when a stock is trading in the overbought ranges as happens to be the case with the iShares Silver Trust (SLV). Secondly, you should be open to the idea of banking some of your profits. If you are ready to book some profits, then having your shares called away will not be something that will concern you too much. 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. When you sell a naked put, you either get in at a price of your choosing, or you get compensated for your efforts via the premium you received when the puts were sold.
You have to own shares in the company to be able to sell covered calls. If you don't 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. As the stock is overbought right now, it would not make sense to purchase shares just to be able to sell covered calls. Additionally, the U.S. dollar's long-term trend is still strong and there are signs that the consolidation should end soon. On the other hand, the Eurozone is still in a mess and despite this upward move, the Euro is already showing signs of stress. A stronger dollar will have a negative impact on silver and this in turn will put downward pressure on the price of iShares Silver Trust. As it is already trading in the overbought ranges, it is ripe for a pullback.
For those who are new to options we are briefly going to examine the benefits of 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
- 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 lovely run after bottoming in the $26 ranges (indicated by the lower brown line). It traded past $30, a zone of former resistance with very little effort. However, the stock has had a hard time trading past $34. Each attempt so far has failed and is now in the processing of topping out.
Every time the stock has tested the +2 standard deviation Bollinger bands it has pulled back (indicated by the purple boxes. It is currently very close to testing these bands. In the interim, the stock could still spike upwards and trade north of $35 before correcting as it did back in February. We would wait for a test of the $34.50-$35.00 ranges before selling the calls. Consider waiting for a test of the $30.00 ranges before you sell any puts. A close below $32 will be a strong indication that the stock should at least test the $30.00 ranges before trending higher.
The March 13, 2012 36 calls are trading in the $1.31-$1.33 ranges. If the stock trades to the suggested ranges, these calls should trade in the $2.00-$2.10 ranges. We will take the midway point and assume that these calls can be sold for $2.05 if the stock trades to $35.50 or higher. If the shares are not called away, you walk away with a gain of 6.00 in roughly five months. If the shares are called away, you gain 7.30% based on a share price of $35.50.
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 plays such as Philip Morris International, Inc. (PM) and Linn Energy (LINE). As a bonus they both offer pretty good yields of 3.6% and 6.9% respectively. Philip Morris has consecutively raised its dividend for 3 years in a row, had a 3 year dividend growth rate of 12%, a sustainable payout ratio of 61% and divided was recently raised from 77 cents to 85 cents.
Linn has a five year dividend average of 9.00%, a very healthy current yield of 6.9%, has raised its dividend consecutively for two years, and also has a very manageable payout ratio of 59%. It increased its distribution payments by over70% since going public and it has a top notch management in place. The company raised EBITDA guidance from $1.35 billion to $1.36 billion. Management wants to double natural-gas production to over 800 million cubic feet of gas equivalent per day. The company announced roughly $2.8 billion worth of acquisitions and joint-venture agreements this year alone. Its recent acquisitions are expected to add roughly 300MMcfe/d of production and increase total reserves by 1.7 Tcfe to 5.1 Tcfe
The March 2013, 29 puts are trading in the $1.00-$1.01 ranges. If the stock pulls back to the $29.50-$30.00 ranges, these puts should trade in the $2.00-$2.10 ranges. Consider waiting at least until the stock trades to the $30.00 ranges before you sell any puts. We will assume that these puts can be sold at $2.00 or better if the stock trades down to the stated ranges.
If the stock trades below the strike price the puts were sold at, the shares could be put to your account. If the shares are put to your account, your final cost when the premium is factored in will work out to $27 per share. If the shares are not assigned to your account, you walk away with a gain of 7.4% 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 13.4%.
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 14.7%.
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 with the lowest possible gains, but you get into the stock at a great price of $27.00 per share. You also earn 6.00% 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.
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 $27.00, and your shares are called away, and you earn 7.3% in roughly five months. One could also argue that this is probably the best long-term outcome.
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.
This is a relatively low risk strategy that provides you with two additional streams of income. The covered calls provide you with an extra stream of income and a predetermined rate of return if your shares are called away. With the puts you have a chance to get into the stock at a lower price or get paid for your efforts.
Selling puts is the equivalent of putting in a regular limit order. The only difference is that you actually get paid for your efforts. If you are looking for other ideas, you might find our latest article on Linn Energy to be of interest. The article makes a long term bullish case for taking a position in the company.
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.