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Despite the Federal Reserve's pledge to keep interest rates near zero until 2015 and to purchase $40 billion worth of mortgage-backed securities every month for an indefinite period of time, mortgage REITS seem to be faring pretty badly. Annaly Capital Management's (NLY) stock has shed over 13% from its high on Sept. 12 to its low on Oct. 15. One reason for this decline could be that investors feel lower long-term interest rates will lead to tighter interest spreads. Mortgage REITS make money by borrowing money at low short-term interest rates and then using this borrowed money to purchase higher-yielding mortgages or mortgage-backed securities. The spread (difference between the yields) is where they generate their income from. Lower spreads equate to small profits and lower income. While this may be true, Annaly has shed a rather large portion of its gains, and if you look at the charts below, you will notice that strong pullbacks have proven to be buying opportunities.

However, just jumping in because the stock has pulled back strongly could prove to be dangerous. That is where the bull put spread comes into play. It provides you with the opportunity to lock in rather lucrative gains over a short period of time without taking on undue risk. We are not making a long-term case for owning this stock, but simply providing a strategy that could allow you to capture quick gains without taking on too much risk. With a bull put spread you simultaneously sell one out of the money put and purchase one put that is further out of the money for a net credit. The long put (the one you purchased) serves as a hedge just in case things do not go as planned. Your total risk is equivalent to the spread between the two strike prices. This would only occur if the stock closed at or below the lower strike price. The maximum gain is achieved if the price of the stock trades at or above the highest strike price.

For novice investors, we are going to outline some of the benefits associated with writing a bull put spread.

Benefits of a Bull Put Spread

  1. It limits your losses if the stock suddenly plunges. Your loss is limited to the total differences between the strike prices of your short put (the put you sold) and long put (the put you purchased).
  2. The ability to profit even if the stock barely budges in price.
  3. The risk is significantly lower than writing a naked put, as your maximum downside is limited by the put option you purchased. For example, if you sold a put on American Capital (AGNC) with a strike at 30 and the stock dropped to zero, your loss would be $3,000 minus the premium you received. Now if you purchased a put with strike at $25.00, your maximum loss would be $500 minus the net premium you received. The difference is rather significant.
  4. The capital requirements are considerably less. With a cash secured put you would need to have enough cash in your account to back the sale of the put. If you sold a put with a strike at $30, you would need to have $3,000 in your account. With the bull put spread, your capital requirement is limited to the spread between the two strike prices. In the above example, the spread is $500. This is significantly less than the $3,000 you would have to put up if you sold a cash-secured put on American Capital Agency with a strike at 30. This strategy should not be abused just because the capital requirements are significantly less. This is a conservative strategy, and by abusing it you will have converted into a speculative strategy.
  5. In the event that the stock declines, an investor can buy to close the short put position and continue to lock in gains from the long put as the price of the underlying stock drops.

Technical Outlook

Click to enlarge images.

The stock has a strong level of support in the $15.00-$15.30 range. This was recently demonstrated when it reversed course sharply after trading down to $15.27 on Oct. 15. The stock also has a tendency to rally after it spiked below the -2 standard deviation Bollinger bands (indicated by the blue boxes in the above charts). As the stock is still correcting, it should test its lows again. If they hold, it will end up putting in a nice double-bottom formation. Double-bottom formations are bullish formations and usually lead to higher prices over the short- to mid-term time frames.

Consider waiting for a test of the lows before putting this strategy into play. A weekly close above $16.50 should result in a retest of the recent highs. Consequently, a close below $15.00 on a weekly basis would most likely push it down to the $14.00-$14.50 range. The support in this zone is very strong and should serve as a floor for lower prices for at least a few weeks.

Charts and Data of Interest

The blue shaded area represents the dividends. The orange line represents the valuation growth rate line. Generally, when the stock is trading below this line and in the shaded green area, it represents a good long-term entry point. Based on this relationship, the stock is currently slightly undervalued. F.A.S.T. Graphs has an estimated earnings growth rate of 3.5% for Annaly Capital Management.

This is interesting and a close call because the stock just started to trend above this line. It needs to stay above $16 to remain above this line. In the short- to mid-term time frames, we think this is achievable as the stock could test its recent highs before pulling back. In general, stocks tend to perform much better when they are trending above the EPS line.

Bull Put Spread

The April 2013 15 put is trading in the $0.73-$0.76 range. If the stock pulls back to the $15.00-$15.27 range, the put should trade in the $1.00-$1.10 range. We will assume that the put can be sold at $1.00 or better.

The April 2013 13 puts are trading in the $0.24-$0.26 range. If the stock pulls back to the stated range, the put should trade in the $0.350-$0.45 range. We will assume that this put can be purchased at $0.40 or better.

Transaction Details

  1. After the sale and purchase of the respective puts, you will have a net credit of $60.00.
  2. Your maximum risk is $140 (the spread of $200 is subtracted from the credit of $60).
  3. Your maximum profit is $60 per spread for a possible return of almost 43%.
  4. Your breakeven point is $14.40

Risks Associated With This Strategy

The main risk is that you overleverage yourself because the capital requirements are so small. Using the earlier example in this article, you would need $3,000 to sell one cash-secured put in American Capital Agency. However, you would only need $500 to write one bull put spread. This means you could technically write up to six bull put spreads. There is always the chance that the shares could be assigned to your account if the stock is trading below the strike price of the option you sold. Thus, the biggest risk is that an investor might abuse this strategy. If the shares are put to your account, you could always turn around and sell them, provided you had the funds in place to cover the initial purchase.

The net credit you get from the trade is usually much smaller than the maximum amount of money you could lose from the trade. Thus, it's would be wise to close the short option out or roll the option before your position hits the maximum loss point. You roll the option by buying back the put you sold and selling a new out of the money put.

Conclusion

The stock has a tendency to rally after a strong correction, especially if it has traded past the -2 standard deviation Bollinger bands. We would, however, wait for the lows to be tested again before putting this strategy to use. Do not abuse this strategy, as there is always a chance that the shares could be assigned to your account. The hedge you have in place via the long put does not prevent this from taking place. This is a conservative strategy, and if you abuse it you will have converted it from a conservative strategy to a speculative one. If the stock is trading close to your breakeven point, consider rolling the short put. To do this, you would simply buy back the put you sold and a sell a new out of the money put.

Options tables taken from Yahoo Finance. Option profit/loss tables sourced from Poweropt.com.

Disclaimer: 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.

Source: Get Into Annaly And Earn Up To 42% With This Simple Strategy