Yesterday I suggested investors should be looking for such opportunities as we enter the summer doldrums and a seasonally-weak period for the market. I named Suncor (SU), Eaton (ETN), and Freeport McMoRan (FCX) as possible candidates in three different cyclical sectors. These are all Zacks #3 Rank or higher stocks and if you are interested in buying them on a pullback, selling a cash-secured put is one great way to do that.
For instance, let's say that you like Freeport and would consider buying it near chart support at $48. If you sold the July 48 put for $2.00, you would be obligated to buy the stock at $48 if shares fall below that strike price before July expiration and you are assigned. But in this case, since you received a $2 premium as a credit for selling the put, your effective buy price for the stock becomes $46.
What if FCX ends above $48 at expiration? You keep the entire option credit, less commissions of course. That's how you generate income on stocks you wouldn't mind buying anyway. You can roughly calculate your rate of return here by using $4,600 as a conservative margin estimate. With 44 days until July expiration, that would give you about a 4.3% return in just over six weeks. Not bad for a stock you wanted to buy "at a discount" anyway.
I say "at a discount" because with FCX currently trading around $49.50 as I write, this strategy allowed you to pinpoint the below-market price you wanted to buy the shares for. What's more, you have several combinations of strike and expiration to custom tailor the strategy to your risk-reward preferences. You could go out to January options and down to the 45 strike, which you might be able to sell for $5 if the stock drops another dollar or so. That would give you an effective buy price for the shares near $40.
In this case, you have taken on more time risk, but you also received a bigger up front option premium for that risk. That's the nature of selling puts, so consider yourself in the insurance business when you do so. You are providing liquidity and insurance to those currently hedging their FCX positions. For full details on the obligations and risks of selling puts, be sure to talk to your broker and ask them for educational resources like the PDF booklet "Characteristics and Risks of Standardized Options," published by The Options Clearing Corporation.
The main thing to keep in mind is to treat the short put strategy as an investment in the stock. Think and act as if you plan to buy the stock at the strike price, less the credit received, and you will have the right frame of mind because the strategy carries all the risks of being long stock. And a great time to implement the strategy is when the market is in a fear-driven move where the prices of options are rising to do a spike in implied volatility, much the way the VIX rises during sell-offs.
I'll revisit this strategy many times over the coming months as I expect a sideways-to-lower environment for stocks. We should get some good opportunities to either generate income on our favorite names or simply buy them "on sale." That's using puts strategically to increase your returns and target pre-determined entry points with an overall more efficient use of trading capital. And, when used on high quality stocks from the Zacks Rank stock rating system, that's smart investing when the rest of the world is running for cover.
Kevin Cook is a Senior Stock Strategist for Zacks.com
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