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.
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