Baidu (NASDAQ:BIDU) needs no introduction. But the stock desperately needs friends right now. It is trading at $103, 4 points from its 52 week low. So, if you like Baidu as a company and as a stock but are concerned that the market's overreaction to Baidu's earnings and the election results aren't over, here is something you can try. Selling Baidu put options.
When you sell a put:
- You are taking a bullish position on the stock, contrary to the misconception that when you do anything with "puts" you are being bearish.
- You get a premium in your account right away for the obligation to buy the stock at the price you want on the date you want. So, you decide the date and the price you want to buy and they pay you for it. Simple isn't it.
- But you are taking a "risk" in that if the stock drops well below your strike price, you still have to buy the stock at the that price you chose and not at the open market price.
- You believe a stock will not drop below a certain level and if it does, you want to be a buyer.
An Example: Below is Baidu's option chain that expires on Jan 18th 2014. Let's pick the $120 put for example. For selling one contract (one contract = 100 shares) you need to have a cash balance of $12,000 in your account. The premium on this particular put is at $27.60 per share, that is 2760 for a contract.
#1: Baidu is well above $120 at the time of expiration. Your option expires worthless and you net 23% for about a year for your willingness to put aside $12,000 on this contract.
Risk: If Baidu really rockets up from here and goes to, say $150, your option returns will be lower than the stock returns. But you are taking on lesser risks.
#2: Baidu is at or below $120, you are obligated to buy 100 shares at $120. Remember, you already netted $27.6 per share when you sold the put. So, your cost basis is $120-27.6 = $92.4. As long as Baidu is above $92, you will have a positive return because of this put transaction.
Risk: The risk in this scenario is that if Baidu really tanks in the next 12 months, you will still have to buy your shares at $120 and not how much ever Baidu is trading at.
Why Is This a Good Ploy And Conclusion?
- Baidu's 2013 EPS estimate is for $6.40/share. For Baidu to trade below your $92 price, Baidu's PE should drop to a historic low of 14.
- Baidu does not pay a dividend. If you sell puts in stead of owning shares outright for a dividend stock, you can be at crossroads about missing the company's dividend payments. But if you are interested in Baidu, you do not have that headache.
- Baidu is a volatile stock. Volatile stocks have a higher premium when you sell puts than stable consumer staple stocks.
- On days like the ones last week when growth stocks took a beating, the premiums are usually fatter.
- Selling puts on stocks you are bullish about is a good strategy to generate income. However, there are some risks like the ones stated above. Please evaluate your risk tolerance before playing options.
- Note: Transaction fee is ignored in the calculations above as it varies for each individual.