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W. Edward Olmstead
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Dr. W. Edward Olmstead (www.olmsteadoptions.com) currently serves as Chief Options Strategist at Olmstead Options Trading Strategies and is the author of "Options for the Beginner and Beyond," top-rated by customers on Amazon.com. From 2003 - 2007 he served as the original editor of... More
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  • ACQUIRING STOCK BY SELLLING PUTS ----- A SOUND STRATEGY? 2 comments
    Jun 16, 2013 7:24 PM | about stocks: ASTX

    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 (NASDAQ: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.

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Comments (2)
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  • Lc_match
    , contributor
    Comments (125) | Send Message
     
    Well, it's at 4.02 today and dropping. Neither approach is better than waiting until it turns. A crappy stock is a crappy stock no matter how you buy it. But the naked puts will get the stock at 4.18 with one set of commissions, while the buy/sell calls/roll strategy will generate a lot more commissions to get this dog for 4.15. And he could roll the puts down a strike and out a couple months to save the 10-15% capital loss. Only opportunity cost then. I'd rather have all my capital and 6 months wasted time than buy a stock at 4.15 (or 4.60) that goes to 3.00. Or maybe the dude knows the stock will go to 5.00 by expiration and just wanted to make .32 on a 4.60 margin investment. Who knows?

     

    Might be more convincing to explore this strategy for FDX or CAT or JNJ or some other stock where it makes sense rather than a penny stock.
    25 Jun 2013, 11:18 PM Reply Like
  • W. Edward Olmstead
    , contributor
    Comments (49) | Send Message
     
    Author’s reply » Lc_match,
    Well said and further illustrates the questionable strategy of selling puts to acquire stock, particularly for a high risk stock.

     

    Even though ASTX stock back up to $4.43, its chart looks like it is in a downtrending channel. Could now buy back the Jul 4.5 puts for $.30, which might not be a bad idea.
    3 Jul 2013, 05:17 PM Reply Like
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