How to Sell Naked Puts for Big Income

by Lawrence Meyers | May 22, 2013 12:17 pm

Rather than continually write articles focusing on options strategies and presenting theoretical examples, I thought I’d offer up a few trades I made recently to provide some real-world rationale for my goals and a road map of how I accomplished them.

Most of my options trading centers around collecting premiums to enhance income. In the old days, I used to buy a stock I liked and then sold covered calls against it. The problem was that these stocks were occasionally called away, and that meant I missed out on some upside, and sometimes missed out on substantial upside!

That’s when I switched over to selling naked puts, often with stocks I already owned that I felt were undervalued. My rationale is that if the stock got put to me, I’d be glad to take that stock at an undervalued price, with further downside protection based on the premium I’d collected.

That’s what I’ve done frequently with Dollar Tree (DLTR[1]). On April 17, with the stock trading right at the strike price of $47.50, I sold naked May 47.50 Puts for $1.51 each. With the stock then trading at 17 times this year’s earnings, on long-term projected growth of 18.4%, I was very comfortable with this trade. In addition, 99 Cent Only Stores had been bought out at a price that would have been equivalent to $43 for Dollar Tree, and that was last year. I felt $46 was a solid floor for the price.

Dollar Tree closed well above $47.50, so that was $151 of free money for me per contract. That gave me a 36% annualized return on that trade.

I’m also a fan these days of Francesca’s (FRAN[2]), the boutique women’s accessories chain. On May 8, the stock traded at $27.50. I sold the May 27.50 Puts for 80 cents. The stock was trading at 21 times this year’s estimates, with long-term growth pegged at 26.5%. Again, an undervalued stock I wouldn’t mind having put to me. FRAN stock wasn’t put to me, though, and instead yielded a 33% annualized return.

Priceline (PCLN[3]) has presented an even more interesting set of circumstances.

On Feb. 5, the company stock traded at $680. It had $74 in net cash, giving it an effective price of $606. The travel industry had good visibility, and Priceline continued to execute — it had $1.5 billion in free cash flow over the trailing 12 months, and was trading at 20 times earnings (backing out its cash) while growing at 20%. January 2014 585 Puts were going for $43. So the worst-case scenario was that I’d have PCLN put to me at an effective price of $542, some 12% below fair value, barring any disaster.

Yet even more interesting was the same strike price but with a July 2013 expiration going for $21. Why be greedy? Plus, the economy — and therefore, the travel industry — had even more visibility just six months out. If I called this correctly, I could sell another put at expiration. So I went with that.

By March 26, things had improved even more. PCLN was now at $700. I decided to buy back the July 585 Puts for $9.20, then sold the October 595 Puts for $23.10. I extended my risk out three months, but the margin of error on undervaluation was still gigantic.

Since then, Priceline stock has exploded. On May 14, it was trading around $790 and has since gone over $820. I bought back the October 595 Puts for $6.75 and sold October 675 Puts for $16.50. My thinking is the stock has soared well beyond the price it started at when I began this endeavor.

I’ve now collected a net of almost $4,500. With PCLN fair value of $606, if the stock gets put to me at $675, backing out the $45 in premiums, I have the stock effectively put to me at $630 per share. That’s still 4% above fair value, and I’m happy to be in that position.

Of course, for that to happen, the bottom would have to fall out in the next five months. It could happen. In the meantime, though, I’m happy to wait.

As of this writing, Lawrence Meyers was long PCLN, FRAN and DLTR and has sold October 675 naked puts against PCLN. He is president of PDL Broker, Inc.[4], which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books[5] and blogs about public policy, journalistic integrity, popular culture, and world affairs[6]. Contact him at pdlcapital66@gmail.com[7] and follow his tweets @ichabodscranium.

Endnotes:
  1. DLTR: http://studio-5.financialcontent.com/investplace/quote?Symbol=DLTR
  2. FRAN: http://studio-5.financialcontent.com/investplace/quote?Symbol=FRAN
  3. PCLN: http://studio-5.financialcontent.com/investplace/quote?Symbol=PCLN
  4. PDL Broker, Inc.: http://www.pdlcapital.com/
  5. written two books: http://www.investorplace.com/author/lawrence-meyers/
  6. blogs about public policy, journalistic integrity, popular culture, and world affairs: http://www.ichabodscranium.com/
  7. pdlcapital66@gmail.com: mailto:pdlcapital66@gmail.com

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