We are going to 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 Seadrill Limited (SDRL). You should also be open to the idea of banking some profits, as the thought of having your shares called away should not bother you.
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. Seadrill Limited is trading in the overbought ranges currently, and it would not make any sense to purchase the shares just to be in a position to sell covered calls.
If you are new to options, then the following information will prove to be very useful.
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.
It could be argued that the stock has put in a triple top formation. It has tested the $41.70-$41.95 ranges three times and on each instance, it closed below $41.70. The first time was on the 27th of August, the second time was on the 13th of September, and the third time was on the 18th and 19th of this month. These last two instances will be treated as one in terms of the triple top count. There has to be an interval of time between each top. Triple tops are viewed as being even more bearish than a double top formation. It illustrates that the zone of resistance is very formidable and that the stock is running out of steam. The only time it managed to trade above $41.95 was on the 29th of February, but these gains were short lived. It gapped down on the following day and then went to shed over 26% before bottoming in June.
Additionally, the stock also has a tendency to pull back each time it tests the + 2 standard deviation Bollinger bands (shown by the yellow boxes in the above chart). It has just tested these bands now and coupled with the fact that it is trading in a zone of very strong resistance, there is a good chance that the stock is getting ready to correct again. As there is a chance, it could spike upwards and test its Feb 29, 2012 highs, we would wait for it trade to the $42.00-$42.50 ranges before selling the calls.
In terms of selling puts, we would wait for the stock to trade at least to $38 before selling the puts. If it closes below $38 on a weekly basis, it could trade down to the $35.00-$35.50 ranges before putting in a bottom. Our suggestion would be to divide your money into two lots and sell one lot of puts when it trades at $38.00 and the other if and when it trades down $35 or better.
We will compare Seadrill against the competition using various metrics. This will help give you an idea of how it fares against its main competitors. If you feel a competitor would make for a better investment, you could put the same strategy that is outlined below to use.
M= Million B= Billion
The April 2013, 42 calls are trading in the $1.65-$1.75 ranges. If the stock trades to the suggested ranges, these calls should trade in the $2.00-$2.15 ranges. We will assume that the calls can be sold at $2.00 or better. If the shares are called away, you will walk away with a gain of $2.00 per share or 5%. If the shares are not called away, you will walk away with a gain of roughly 5% in 6 months.
If your shares are called away, you can always deploy the money into another good long term dividend play such as Line Energy (LINE). Linn Energy has a five-year dividend average of 9.00%, a very healthy current yield of 7.00% and has raised its dividend consecutively for two years. It has a manageable payout ratio of 59%, and has increased its distribution payments by over 70% since going public. 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. Management wants to double natural-gas production to over 800 million cubic feet of gas equivalent per day. Finally, the company raised EBITDA guidance from $1.35 billion to $1.36 billion.
The April 2013, 37 puts are trading in the $1.55-$1.80 ranges. If the stock pulls back to the stated ranges, these puts should trade in the $2.10-$2.20 ranges. We will assume that these puts can be sold at $2.10 or better.
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 $35.90 per share. If the shares are not assigned to your account, you walk away with a gain of 6% in 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 11%.
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 get into the stock at a great price of $35.90 per share, and you also earn 5.00% 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.
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, your shares are called away, and you walk away with a gain of 11% in roughly six months.
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 $35.90, and your shares are called away, and you earn 5.00% in roughly six 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. Normally, this should not be an issue as you only sell puts if you are bullish on the stock and would not mind owning the shares at a 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.
Seadrill Limited is trading in the overbought ranges, and it has consistently failed to close above $41.70. The only time it managed to close above $41.70 was back in February, and it managed to do this only for a day. It subsequently shed over 26% of its value before bottomed out in June. Given the resistance it faces in the $41.70-$42.00 ranges, it makes sense to sell covered calls and attempt to get into the stock at a lower price.
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. As long as you are bullish on the outlook of the stock this is a low-risk strategy. Selling puts is the equivalent of putting in a regular limit order. The only difference is that you actually get paid for putting in a limit order. If you are looking for other ideas, you might find our article where we examine Freeport-McMoRan in detail to be of interest.
Options tables and competitors data 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.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.