I’m a big fan of selling naked puts and covered calls. Both strategies generate income, which is the primary attraction. However, they also provide ways to play a degree of uncertainty I may have in a given stock.
For instance, Wynn Resorts (NASDAQ:WYNN) is, to me, the premier name in Vegas resorts. In fact, I’m due for my first visit to the Encore resort next month. Steve Wynn wisely capitalized his company with a relatively conservative degree of leverage when he launched it, and it has served him well during the financial crisis.
Now, I like Wynn’s prospects over the long term, but the near term may present a few challenges. Vegas revenues are in the low- to mid-single digits. Macau revenues are much stronger, but his new resort isn’t scheduled to open until 2015 at the earliest.
So, should you buy the stock now for the long term, even though growth won’t really kick in for awhile? That’s why I like options here. The stock is trading at $101, off its $160 high. You could sell a naked put, such as the January 2013 95 put for $10.50, and collect over a thousand dollars. This gives you downside protection all the way to $85, and if the stock gets put to you, I’d be thrilled to have Wynn at an $85 equivalent.
J.C. Penney (NYSE:JCP) presents a similar opportunity. The retailer is going through a challenging turnaround, which I believe will ultimately succeed. But as an investor, am I ready to commit capital to go long the stock? What if things don’t work out? The stock is at $24. That’s about as low as it’s been in quite some time.
So, I sold January 2013 24 naked puts for $3.80 each, then used the premiums to buy January 2013 29 calls for $2.05. The net result is $175 in cash from each contract. If things aren’t great in January, I’ll have Penney at the equivalent of $22.25, a price that discounts things being really messed up.
On the other hand, if the turnaround goes well in the next few months, I can get in at the equivalent of $27.25. Given the big drop when Penney announced its terrible quarter, the stock could go above $30 in a single day of good news.
Finally, I love First Cash Financial Services (NASDAQ:FCFS). It’s the most well-positioned pawnshop operator in Mexico and significantly undervalued. With the stock at $37 and a fair value of over $50, it’s a great time to buy more. On the other hand, I already have a ton of stock in my long position and don’t want to throw my portfolio balance too out of whack.
So, I’ve been selling near-the-money naked puts each month. Right now the stock is stuck in between strikes of $35 and $40, but on Monday the stock was at $35.60, so I sold July 35 (naked) puts for $2.85. So, I collect the generous premium. If the stock gets put to me, I’m thrilled to have it at the equivalent of $32.15 — far below fair value.
Option plays offer many advantages depending on the situation and your perception of the future. They may be complicated in some cases, but they’re worth educating yourself about.
Lawrence Meyers is president of PDL Capital, Inc., which brokers secure high-yield investments to the general public and private equity. You can read his stock market commentary at SeekingAlpha.com. He also has written two books and blogs about public policy, journalistic integrity, popular culture and world affairs.