How to Invest/Trade in Under-Priced Companies 2 - Call Spread and Naked Put

There are many variations and various names accompanied to this strategy, but here is one spin on it, which can be added to and developed over time.

The point in this article is about the amount of credit a trader can receive on the initial placement of the trade. The opportunity to receive a credit upfront and further profit from a rise in the share price.

In this example, we are using a 36.50 stock and we are looking at options in the future of about 180 days. We have done our analysis and believe that the stock will rise over the next period of time but with in the 180 days.

We are looking for a credit trade so we will angle the trade like this;

• Sell a Put at $30 with the expiry date 180 days in the future for a credit $0.99
• Buy a Call at $37 with the same expiry date for debit of $3.25
• Sell a Call at $39 with the same expiry date for credit of $2.44

Combined this will give us a total of about $0.18 in credit for the trade. (0.99+2.44-3.25). So that means that as soon as we place the trade we will receive $18 for every contract.

This may not sound like a lot but let us break it all down.

Our risk on this trade is if the share price is below $30 in 180 days time on the expiry date. Based on the individual traders research will determine the probability of this event occurring. Effectively the share price needs to fall about 18% for the trader to question the investment.

Now if the share price rises our profits are capped to the difference between the bought call and the sold call, which is $2. Meaning if the share rockets above $39 and goes to $50 the trader is still only profiting $2 per contract.

The anticipated Margin for this trade is about $430 (rough estimate) meaning the following;

1) When the trade is placed our return on margin is roughly 4%

2) If the market goes above $39 before expiry our profit will increase by $200 making a total return on margin of $218. This is roughly a 50% over 6 months.

If the share price is between $30 and $37 at expiry we make about 4% return anything above $39 the trader, stands to make about 50% return on margin.

If the share price is below $30 on expiry date, the put options will fall in line with the naked put option strategy and a trader will assess the various risks, information and probability etc at that stage.

The benefits of using this style of option trades is that on placement of the trade it makes money. After that, it is up to the market forces which way it will go. If the market climbs, there is a hefty return.

Why not just buy a Call? We will cover this later but the bottom line is the cost. In this example, it would cost the trader $325 per contract, and if the market goes up the trader makes money, but if the market falls, the trader loses money. There is no margin of safety. Doing the trade as per the method noted above, at least there is no upfront cost to the trade, just an ongoing maintenance margin cost, which you get either way.

Their are various ways and strike prices to place the call spread and the put, but the point is to always try to get a small credit for the trade and minimize risk by lowering the naked put. A general rule I use is, the bought call is as close to share price as possible and the short call is about 10% of the share price above the bought call. This is a general starting  guide line and can be modified once the stock and option values are identified.

How to Invest/Trade in Under-Priced Companies - Selling naked puts

After some thought it was relatively prudent to start putting up some strategies used to trade and invest in under-priced listed companies. Their are multiple ways to enter a stock without buying the stock outright. Their are some pros and cons with any which way, but the point is diversification of strategies helps increase cash flow and reduce risk.

Due to the amount of content this has turned into a series of blogs.

Once a opportunity has been identified and we believe the stock is in a good position to increase in value we can look at the following.

Opportunity 1:

Naked Put. This is where we would look at selling a put to generate income but also has the potential to add a buffer should the share move sideways for a while or slightly down.

An example would be lets say the share is trading at 56.38 and their is a put available at $45 trading for 0.33 cents. This means that we can sell this put with a strike price of $45 for 0.33cents with expiry of the option in 25 days time. As the multiple is in 100s lots of shares this will mean that we will receive $33 for this transaction. We receive this $33 as soon as we place the order. What does all this mean? well in short, as long as the share price remains above $45 between now and expiry date we get to keep the $33. This means that the share price has to fall another roughly 20% before it affects our position. Our Margin for managing this trade is about $600 meaning a return on margin of about 5.5% over 25 days.

The risks obviously are that the share price falls further and a few things can take place, if the share price is below our strike price on expiration date or the week before coming into our expiry date, we may look at;

a) Rolling our put down and out. As long as their is value with trading this way and it makes sense from a probability stand point and a return standpoint then we could look at this as an option. In my opinion if the share price is getting hammered and effecting my strike prices, i would look at this roll down and out as a separate trade with its own risk and probability. I would only look at doing this trade if it makes mathematical sense. If i cannot find a logical and mathematical way to view the continuation of this trade, all bets are off and i recommend to move on.

b) Close the position and move on.

c) Get exercised and be the proud owner of some shares in a company, where you can then write calls on the shares or hold for dividends etc.

d) On expiry date the trader opts to get exercised and then write more puts and calls on those shares. Depending on your analysis and strategy for the stock, the stock in your opinion may just be having a bad day and is a fantastic buying opportunity. If this is the case, the share price has just fallen 20%. In this scenario you now own 100 shares per contract at $45 costing you $4500 per contract. A trader could then sell another put at say $37 strike and sell a call at $50. What this means is that if the share price is below $37 at the next expiry and the trader ends up owning more stock at $37 then the traders breakeven is ($37+$45/2) = $41 minus all the credits from the selling of the calls and puts. this strategy is an interesting one, but not one to take lightly. This is due to the fact that if the share price keeps falling your losses will quickly compound and could effectively wipe out your trading account. If this strategy is something a trader is looking at, they need to be certain they are right on their valuation of the stock, and that it wont go broke over night, and secondly but probably more importantly if the stock did go broke the added shares and risk taken on will not have a dramatic effect on the overall portfolio.
On the positive side if the share price does rally from $45 to $50 or above at expiry this means that the trader has collected all the premiums of all the puts and calls written and also made the difference between $45 and the $50 call strike making for a healthy $5 profit per 100 shares.

This is no way is the limitation of potentials, but the point here is look at income generating strategies using naked puts and what can happen if things go wrong and to consider different methods of managing the position.