by Lawrence Meyers | February 4, 2014 9:37 am
Naked puts are one of my favorite forms of options. Prior to using naked puts, I had always purchased an underlying stock, then sold covered calls against those positions to generate income. The caveat was that these were always stocks that I wanted to own, or at least had no problem owning, in case the price should fall significantly.
Another caveat was that, in my case, I always chose stocks that were undervalued. If the price fell, then I just held an even more undervalued stock.
[1]Then I realized I could accomplish the same thing but without having to tie up my funds in the underlying security. I could sell naked puts against the same stock instead and use the funds for other things. I still collected a premium, and if the stock got put to me, then I’d still be handed an undervalued security I was glad to own.
And that’s the other caveat for naked put sellers: Make sure you have the money to buy the stock if it gets put to you, or be ready to buy back that put at a loss if need be.
Here are a couple of trades I like right now:
The first slam-dunk trade is with Apple (AAPL[2]). The market completely overreacted to a rather solid earnings report from AAPL and sent the stock down 8%. As I write, AAPL stock is right around $500. The first thing I do is look at AAPL’s net cash position. It’s got $40.7 billion in cash and short-term securities, and another $118.1 billion in long-term investments. Back out the $17 billion in debt, and AAPL net cash is $141.8 billion, or $157 per share in net cash. Wow! So AAPL stock is effectively selling for around $360.
Earnings are slated to grow 8% this year and next, but 19% annually over the next five years, with FY14 EPS projected to be $43.08. I would conservatively give AAPL stock a price-to-earnings ratio of 12, meaning fair value would be about $516. So here it is, trading at an effective price of $348.
If you aren’t comfortable buying the stock outright because of the recent volatility, that’s why you can sell a naked put, and reduce the risk by choosing a strike that’s well out of the money. The July 455 put[3] is selling for $14.67, which is a nice premium. If the stock does get put to you, you get it at an effective price of $455 (strike) – $157 (cash) – $14.67 (premium) = $283.33. That’s at about 6.5 times earnings, and that’s why it’s a slam dunk. (And even not backing out the cash, you’re looking at buying AAPL stock at nearly $440 a share. You don’t think it’ll rebound from there?)
I myself sold the Jan 2015 $470 put before the big crash, for $27. I’m sleeping well at night.
The other move you can do is to sell a naked Priceline.com (PCLN[4]) put. With the stock at $1,124, and $6.5 billion in net cash, Priceline has $118 in net cash, so the effective stock price is $1,006. Analysts see 20% long-term growth, so with FY14 earnings projected at $51.15, I’d put fair value on a P/E basis at $1,030. So here, I see PCLN stock trading at fair value. If I sell a put below this price, I’d be getting the stock at a bargain level.
The July 900 put is selling for around $19 right now. That’s a fantastic return. I’d be happy to have PCLN stock put to me at an effective price of $881!
As of this writing, Lawrence Meyers holds an AAPL January 2015 470 Put and a PCLN July 940 put. 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 @ichabodscranium.
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