How to Make Better Naked Puts

by Lawrence Meyers | November 15, 2013 8:50 am

I’ve got a few put naked put trades out that I’d like to consider perfect, though I technically can’t say that for sure until expiration. However, they are a perfect example of how I like to sell naked puts on very specific stocks.

My criteria is as follows to sell naked puts:

  1. Make naked puts against stocks that have just reported earnings: This gives you clarity! It’s the point of maximum information that you’ll have about the company for the next few weeks. If the company is on solid footing and is executing well, and if it doesn’t foresee any surprises in the next quarter, then you can feel relatively safe about selling puts and not getting shares put to you and seeing the underlying price fall.
  2. Make naked puts against undervalued stocks: You want shares put to you that you believe are undervalued at the strike price. After all, what’s the point of having a stock put to you that is overvalued? It just means you are taking on greater risk of a substantial decline in the underlying stock. No premium will make a massive decline in the stock feel like a good trade.
  3. Look for a 3% return for four to seven weeks out: The higher the premium, the better. I’ve historically found that a 3% return for a four-to-seven-week period of exposure between sale and expiration is a good target. That translates to a 23%-39% annualized return.

Two stocks met these criteria recently.

Portfolio Recovery Associates (PRAA[1]) reported earnings on Nov. 1 and blew away estimates. PRAA continues to execute, and I believe it is substantially undervalued. It’s a debt collector, and that business is going gangbusters[2]. I already hold PRAA shares, but I’d be happy to take on more.

Rather than purchase more, however, I often like to sell naked puts and collect the premium. If the shares get put to me, great! If not, fine — Ive made some nice money.

PRAA was trading right around $57.20 last week. I sold the Dec 56.67 puts for $2. First, that’s a 3.5% return for the holding period. Second, if PRAA is put to me, I’m getting it at an effective price of $54.67, well below fair value. Third, by selling naked puts out-of-the-money, I have additional downside protection.

Now let’s move to another stock I’ve followed for a long time, First Cash Financial Services (FCFS[3]). This pawnshop operator is killing it in Mexico, and is the leading pawn operator in that country at this point. FCFS has substantial cash flow, uses it to open new stores, and understands the Mexican consumer. I believe First Cash is undervalued, and have held the stock on other occasions.

When FCFS was trading at $60, I felt it was still a value. In this case, I sold the Dec 60 puts[4] for exactly $1.80, hitting my 3% target for the six-week holding period, or a 25% annualized return. I see no reason why FCFS would crater between now and then.

Because I’ve worked in the alternative finance industry for a long time, I’m able to judge if any surprises might pop up, and I see none. That makes this a nice trading opportunity with low risk.

Lawrence Meyers owns shares of PRAA. He has sold puts against PRAA and FCFS. He is president of PDL Broker, Inc.[5], which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books[6] and blogs about public policy, journalistic integrity, popular culture, and world affairs[7]. Contact him at pdlcapital66@gmail.com[8] and follow his tweets at @ichabodscranium.

Endnotes:
  1. PRAA: http://studio-5.financialcontent.com/investplace/quote?Symbol=PRAA
  2. that business is going gangbusters: http://investorplace.com/2013/11/small-caps-to-buy-praa-ecpg/
  3. FCFS: http://studio-5.financialcontent.com/investplace/quote?Symbol=FCFS
  4. puts: http://finance.yahoo.com/q/op?s=fcfs&m=2013-12
  5. PDL Broker, Inc.: http://www.pdlcapital.com/
  6. written two books: http://www.investorplace.com/author/lawrence-meyers/
  7. blogs about public policy, journalistic integrity, popular culture, and world affairs: http://www.ichabodscranium.com/
  8. pdlcapital66@gmail.com: mailto:pdlcapital66@gmail.com

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