W. Edward Olmstead's  Instablog

A frequently mentioned strategy for acquiring shares of a desirable stock is that of selling naked puts and waiting to have the stock assigned. Advocates of this strategy argue that this is a great way to buy a stock at a discount price. While there is some potential value to this strategy, it is unclear that this approach is always a sound way to acquire a stock.

Let's look at a case that was recently profiled in the financial press to investigate the pros and cons of acquiring stock by selling naked puts.

Astex Pharmaceuticals Inc (ASTX) is a popular stock with a price that has been in a steep decline since the beginning of May. Recently the stock price appears to have bottomed out near $4.50 per share.

On June 11, with ASTX stock trading at $4.60 per share, a single order to sell 5,000 contracts of the Jul 4.5 puts was filled at $.32 per share. There was no evidence that this was part of a spread order that would have hedged the short puts. Ostensibly, this order was placed by a put seller (firm or individual) that has some potential interest in owning 500,000 shares of ASTX stock.

Positive side of this strategy

The arguments in favor of this trade point out that if the stock price is above $4.50 at the July expiration date, the short naked puts will expire worthless and the seller keeps the $.32 per share. On the other hand, if the stock price is below $4.50, the seller will be assigned the stock and thereby acquire 500,000 shares at the discounted price $4.18 per share [4.50 - .32 = 4.18]. An important point about this stock acquisition strategy is that while the put seller does not need to have all of the cash available to purchase the stock prior to the options expiration date, there will still be a substantial margin requirement imposed as soon as the puts are sold.

Negative side of this strategy

To see the negative side of this strategy of selling naked puts, suppose that ASTX stock has bottomed out near $4.50 a share and rises to $5.00 or higher by the July options expiration date. The put seller may regret not having decided to buy 500,000 shares of stock at $4.60 per share while simultaneously selling the Jul 5 calls for $.35 per share. That combination represents a discounted stock price of $4.25 per share [4.60 - .35 = 4.25], and if the stock price is above $5.0 at the July options expiration, the stock will be called away for a total profit of $.75 per share [.35 + (5.00 - 4.60) = .75]. On the other hand, if the stock price begins to fall, it may be possible to roll the short Jul 5 calls down to the Jul 4.5 calls so as to receive a total of say $.45 from the two short call transactions, thereby reducing the cost basis of the ASTX stock down to $4.15 per share [4.60 - .45 = 4.15].

Conclusion

The primary point of this discussion is if you are bullish on a stock that is near a bottom in price, you may be better off buying the stock than going through the acquisition process of selling naked puts. If you are correct in your assessment that the stock is ready to start moving up, you are likely to achieve a better return by simply buying the stock and selling out-of-the-money calls. Even if the stock continues to fall a bit lower, your cost basis for stock ownership may be about the same as that of the put selling strategy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

For those of you who have been following our FB earnings protection trade, the moment of truth is upon us, with the company issuing its report after the close tomorrow (1/30).

Going back to last Friday (1/25), those who had entered our suggested trade were faced with a decision. With FB stock traing around $31.50, the expiring short weekly Jan 30 call was in-the money and a decision had to be made to either (i) allow your stock to be called away for $30 per share plus the $.70 per share collected from selling the weekly Jan 30 call and weekly Jan 26 put. You could still continue holding the Jan 27 put that expires this week in anticipation of a stock price pullback following the earnings report, or (ii) buy back the in-the-money Jan 30 call for a net cost of $0.80 per share in order to hold the stock through the earnings report. Again, the Jan 27 put would be in place to insure a minimum sale price of $27 per share through this Friday (2/1). Either decision would leave you well placed in the event of an earnings disaster such as that recently observed when Apple Inc (AAPL) issued a disappointing report.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

For those of you who have been following the FB trade that was proposed in my previous Seeking Alpha articles and blog entry of 8/15/12, the residual option position is now showing a profit of 76%. Since the residual position includes the long Jan 16 call that will be expiring this Friday (1/18/13), a decision needs to be made. The basic choices are: (i) sell the Jan 16 call and collect the profit, (ii) exercise the call to become the owner of 100 shares of FB stock at a price of $16 per share. (iii) roll the Jan 16 call into a later month.

If you wish to continue participating in the price movement of FB, choice (iii) provides that opportunity without the need for extra capital to purchase the stock. Even after choosing (iii), there are further selections to be made in terms of which expiration month and which strike price should be used.

Rolling the Jan 16 call into a June call option will provide for another five months of participation in the FB price movement. Here are a couple of possibilities involving June options : (iii-a) Roll the Jan 16 call into the Jun 17 call for a small profit that will cover your commission costs. The Jun 17 call has a delta of 0.96, which means that this option will capture essentially all of the price movement of the stock. (iii-b) Roll the Jan 16 call into the Jun 23 call, which will produce enough profit to cover the cost of your Jan 16 call and thus represents a free trade for the next five months. The Jun 23 call has a delta of 0.83, which will also mimic the price movement of the stock quite well.