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10% Return -- Can You Hear Me Now?!

By Costas Bocelli October 13, 2011 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

In my Tycoon Report article from this past June 16th, Better Than 10% Yield… In This Environment?, I outlined a very powerful options strategy and shared a detailed actionable example.

The strategy entailed the sale of ONE Put option contract as a replacement for every 100 shares of stock that you were considering to purchase.

The idea is to sell an out-of-the-money Put option (lower than the stock’s spot price) at a strike price that you would be prepared to own in the event that the stock happened to indeed trade lower.

Of course, for selling the Put option contract and obligating yourself to possibly take delivery of the stock until expiration, you collect a premium that is yours to keep.

For many investors, selling unhedged naked Puts can be perceived as a reckless or dangerous strategy.  However, if constructed properly and applied to the appropriate securities, it can be extremely advantageous -- especially in a volatile, oversold market.

Revisiting this prior article can be a great learning experience, and reinforce how to properly apply this option strategy.

If you recall, we applied this strategy on Verizon Communications (symbol: VZ) back on June 16, 2011.

With VZ trading at $35.12, we considered selling the VZ October 33 Puts for a 1.16 credit.  Each Put contract sold would obligate us to purchase 100 shares of VZ at $33 if we were to be assigned.  And each contract netted $116 in cash from the sale.

The thesis behind this type of strategy is to write (sell) Put options on very safe, fundamentally solid companies that we would be comfortable owning either at the current price or, more importantly, at the strike price we sold, which could trigger the obligation.

We outlined the two scenarios that can occur by expiration.  Either the stock price stays above the strike price and we get to book the entire premium collected, or the stock trades below the strike price, which will obligates us to take delivery.

If the latter were to occur, we would get to buy an attractive stock that we like at a discount.

So let’s take a look at the updated daily chart on VZ...

The red arrow shows the day we sold the VZ October 33 Puts for a 1.16 credit, with VZ trading at $35.12.  The green solid line shows the level at which we may be obligated to buy the stock (strike price), and the green dotted line would be our break even in the event we were put the stock.  The break even is the strike price less the credit we took in, so our adjusted cost basis would have been $31.84.

About 120 days have passed since the trade was initiated, which was BEFORE the U.S. debt downgrade and flare up of the European sovereign debt crisis.  Both events -- and the severity of the situation -- were clearly an unknown at the time. 

Notice the price action in VZ -- it did indeed sell-off during the massive market volatility of the past nine weeks, but once it hit that solid area of resistance around the strike price we strategically sold, it held firm.

As you can see, owning Verizon at those reduced levels would have been an attractive result.  But it rebounded smartly off of those oversold levels.

Now wind it back to yesterday’s close and you can see that VZ settled at $36.67.  The October Puts that were sold actually expire next Friday, October 21.  That will terminate the contract and release you from any further obligations. 

The result:  You get to keep the entire amount from the premium sale, AND you’ve made a 10% annualized return.

One very important suggestion...

There are still 6 trading days until expiration, and I always recommend to my subscribers that when you get the opportunity to take risk off the table, free up capital, and lock in substantial gains at a very cheap price, you should look to do so.

For example, the October 33 Puts can be purchased back for as little as $0.02 per contract -- a small but prudent price to pay to terminate the trade a little early. 

The three takeaways from analyzing this play:

1. Use this strategy in stocks you are comfortable owning, particularly at the strike price you decide to sell.

2. Use leverage properly.  Sell the appropriate amount of contracts that coincides with how many shares you would be comfortable owning.  (ONE option contract equals 100 shares of stock.)

3. Don’t be afraid of this strategy -- especially in washed out, high volatility markets.  Use its strength by targeting downside strikes showing compelling support levels that you would welcome into your portfolio.

Happy trading!