by Nick Atkeson and Andrew Houghton | November 17, 2011 9:00 am
The beauty of options is their versatility. The number of strategies suits the number of opinions — many.
In the equities market, market participants have two choices: buy or sell. In the options market, market participants can buy a call, sell a call, buy a put, and/or sell a put. These are the building blocks of all option trades. The vast number of strikes, as well as the number of expirations, allows you to implement strategies to fit your investment thesis, time horizon and risk tolerance.
Options can be as speculative or as conservative as you want. Please note, options carry a certain level of risk. But, so does owning or shorting stock.
The two most-common (simple) options strategies are buying a call and buying a put. If you think the stock is going up, you can buy a call. If you are bearish on the stock, you can buy a put. Not only do you need to get the direction right, but you have to determine whether the options price versus the expected move in the underlying stock over a specific time is inexpensive or not.
Selling calls naked is not recommended. Naked call selling exposes one to unlimited loss. However, selling calls against stock you own, called covered-call writing, can be a very successful strategy to pick up some income and reduce your cost basis in a flat-to-down market.
Selling puts can expose you to significant losses. (Of course, the risks are defined at the outset of the trade, so you know what you’re getting into.) However, selling premium/volatility can be a very effective strategy to generate income. We like selling puts on stocks we would like to own.
One stock we would like to own is Home Depot (NYSE:HD). Its earnings are estimated to grow to $2.35 next year (Jan ’12) from $2.03 last year and to $2.68 next year (Jan ‘13).
Traffic and sales trends are positive. A residential remodeling index hit a new high in September — homeowners from coast to coast are updating their current homes.
Home Depot pays a 3% dividend. The company has signaled its strategy of increasing dividend payouts as an important way to return capital to shareholders. The company is also buying back stock and will likely re-up an authorization once the current $6.8 billion is completed.
So, instead of buying the stock and laying out $38.50 for a 3% dividend, we recommend selling the HD Jan (2013) 35 Puts for $3.90. The margin requirement is roughly $8.60. The return on investment on the margin required is 45% ($3.90/$8.60), or 10.2% on a full cash-secured basis.
Our outlook (and hope) is that stock trades flat to up (or at least above $35). By selling the $35 puts, we are saying that we would not mind owning HD at $31.10 (i.e., the strike price minus the premium collected) if the stock sold off. At this lower level, HD’s $1.16 dividend per share is 3.7%. With the 10-year Treasury note at 2%, we think this is a great level.
Please note to appropriately size all option trades, specifically when selling puts.
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