CHICAGO, June 2, 2011 /PRNewswire/ -- Today, Zacks
Investment Ideas feature highlights Features: Suncor (NYSE:
SU), Eaton (NYSE: ETN), and Freeport McMoRan (NYSE:
FCX).
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http://photos.prnewswire.com/prnh/20101027/ZIRLOGO)
Strategic Put Selling
One of my favorite strategies for making money off of your
favorite stocks is the short or "naked" put, sometimes called
"cash-secured" by brokers because they will require a certain
percentage of your account capital to be used as margin to cover
the potential event of assignment. When you sell a naked put, you
are obligated to buy 100 shares of the underlying at the strike
price if the stock falls below it come options expiration.
Yesterday I suggested investors should be looking for such
opportunities as we enter the summer doldrums and a seasonally-weak
period for the market. I named Suncor (NYSE: SU),
Eaton (NYSE: ETN), and Freeport McMoRan (NYSE: FCX)
as possible candidates in three different cyclical sectors. These
are all Zacks #3 Rank or higher stocks and if you are interested in
buying them on a pullback, selling a cash-secured put is one great
way to do that.
For instance, let's say that you like Freeport and would consider buying it near
chart support at $48. If you sold the
July 48 put for $2.00, you would be
obligated to buy the stock at $48 if
shares fall below that strike price before July expiration and you
are assigned. But in this case, since you received a $2 premium as a credit for selling the put, your
effective buy price for the stock becomes $46.
What if FCX ends above $48 at
expiration? You keep the entire option credit, less commissions of
course. That's how you generate income on stocks you wouldn't mind
buying anyway. You can roughly calculate your rate of return here
by using $4,600 as a conservative
margin estimate. With 44 days until July expiration, that would
give you about a 4.3% return in just over six weeks. Not bad for a
stock you wanted to buy "at a discount" anyway.
I say "at a discount" because with FCX currently trading around
$49.50 as I write, this strategy
allowed you to pinpoint the below-market price you wanted to buy
the shares for. What's more, you have several combinations of
strike and expiration to custom tailor the strategy to your
risk-reward preferences. You could go out to January options and
down to the 45 strike, which you might be able to sell for
$5 if the stock drops another dollar
or so. That would give you an effective buy price for the shares
near $40.
In this case, you have taken on more time risk, but you also
received a bigger up front option premium for that risk. That's the
nature of selling puts, so consider yourself in the insurance
business when you do so. You are providing liquidity and insurance
to those currently hedging their FCX positions. For full details on
the obligations and risks of selling puts, be sure to talk to your
broker and ask them for educational resources like the PDF booklet
"Characteristics and Risks of Standardized Options," published by
The Options Clearing Corporation.
The main thing to keep in mind is to treat the short put
strategy as an investment in the stock. Think and act as if you
plan to buy the stock at the strike price, less the credit
received, and you will have the right frame of mind because the
strategy carries all the risks of being long stock. And a great
time to implement the strategy is when the market is in a
fear-driven move where the prices of options are rising to do a
spike in implied volatility, much the way the VIX rises during
sell-offs.
I'll revisit this strategy many times over the coming months as
I expect a sideways-to-lower environment for stocks. We should get
some good opportunities to either generate income on our favorite
names or simply buy them "on sale." That's using puts strategically
to increase your returns and target pre-determined entry points
with an overall more efficient use of trading capital. And, when
used on high quality stocks from the Zacks Rank stock rating
system, that's smart investing when the rest of the world is
running for cover.
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