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ACQUIRING STOCK BY SELLLING PUTS ----- A SOUND STRATEGY?

|Includes:Astex Pharmaceuticals, Inc. (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.

Stocks: ASTX