I really like companies such as online travel stock Priceline (PCLN), but they trade at very high prices. Thus, I didn’t want to risk buying 100 shares of PCLN stock, only to see it fall 150 points. It’s a successful company, just a volatile stock … so how could I capture some upside but do so at vastly less risk?
I sold naked puts.
One of the big concepts behind options is using them as hedges to reduce risk. For many years, I would generate income by buying a stock and selling covered calls. Then I realized I could accomplish the same thing by not holding the stock at all and selling naked puts against the stock. If I was willing to hold the stock in the first place, then I should be willing to instead get paid to have the stock put to me. This reduced my risk insofar as I didn’t have to put a lot of capital to work by actually purchasing the underlying stock, and I could instead put the money to work elsewhere unless the stock was put to me.
I extended the concept of selling naked puts a few years ago. Let’s use PCLN stock as an example.
As I write, PCLN stock trades at $1,178. I like Priceline over the long term, but I’m concerned about being exposed to a sudden downdraft — particularly if it happens in an overall market correction, and my emotions get the better of me. I don’t want to sell out, take a big loss, only to see it climb back up.
First, I try to assess a fair value for the stock on a quick-and-dirty price/earnings-to-growth basis. PCLN has $4.8 billion in net cash and 51 million shares outstanding, so it has roughly $95 per share in cash, giving it an effective price of $1,083. PCLN is expected to grow EPS 24% to $50.95 per share next year, giving it a P/E of 21. On a PEG ratio, then, it’s actually a little undervalued. So if I have PCLN shares put to me at any price lower than it is now, I consider it a bargain.
I like to choose a strike price about 20%-25% below current pricing to account for a market correction or an earnings miss, while staking out an expiration date at least six months from now so that any such correction has a chance to be negated.
That means I’m looking for a PCLN July 2014 strike of somewhere around $900 (net of cash). That put closed at $20.70 on Monday afternoon. I’ll be glad to take that $2,070, and if the stock gets put to me, fine! I get it the stock at an effective price of $879.30, almost $300 below where the stock actually trades today. If PCLN stock keeps rising, I miss out, but that means my puts will become worth less and less as time goes on and/or the price rises. I can then buy back that put and sell another at a higher strike and/or later expiration.
This is exactly what I did this year. PCLN stock has risen from $623 to $1,178 in the past 52 weeks. Had I bought 100 shares, I’d be on the moon, with a $55,000 paper gain. But I’ll tell you right now, I would not have slept well at all this year, and I would like have sold out out my PCLN stock position piecemeal before I took in that whole gain.
Instead, using this strategy, I’ve collected almost $12,000 in premiums, and exposed myself to much less risk.
Again, it’s important to point out that you should not enter this kind of strategy unless you have the money to cover buying the appropriate amount of shares, and you need to love the stock even in the event of a huge drop in its price.
Other stocks you might consider for this strategy are Amazon (AMZN), since it is a quality company that I’d be happy to own; Visa (V) and MasterCard (MA) because both are part of an oligopoly, have large premiums and arent’t likely to suffer some internal combustion; and Google (GOOG) because … well, it’s Google.
As of this writing, Lawrence Meyers held a naked put position on PCLN April 2014 $900 strike. He is president of PDL Broker, Inc., which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books and blogs about public policy, journalistic integrity, popular culture, and world affairs. Contact him at email@example.com and follow his tweets @ichabodscranium.