1 Simple Investment Strategy You Simply Must Learn

I'm going to let you in on a little secret. My favorite investment strategy is writing puts. This simple strategy has just two possible outcomes, you will either buy your desired stock at a price you are willing to pay or the put will expire leaving you with at least having earned some income for trying. This win-win outcome makes it such an optimal investment strategy for buying a stock that I think it's a strategy all investors need to learn.

I realize that many investors are wary of options and for good reason. If used incorrectly, you can get burned because options involve leverage, which can be dangerous. However, if used wisely options are a great tool to make your portfolio even better.

To put this simple investment strategy into practice, I'm going to run through three examples of companies I personally am looking to buy. These three companies are all onshore oil and gas producers that are working to turn things around after the gas bubble burst. This is where the cardinal rule of writing puts comes into play, you must be willing to buy the underlying stock at the strike price. 

Topping the list of companies I'd like to buy cheaper is SandRidge Energy (NYSE: SD  ) . The oil and gas producer has come under intense pressure from activist investors who don't like the way management has led the company. Further, its share price had been pressured by the debt it took on as it shifted from natural gas to oil; it's focused its attention on becoming the dominant player in the Mississippi Lime. Those past missteps have the company trading at a compelling value – the company currently pegs its net asset value at $32 per share, while those same shares now trade at just over $5 apiece.

I like the turnaround story, but I don't want to pay a penny more than $5 a share for the company because much risk still remains. I could just place a limit order and hope it hits, but by using put options as my investment strategy I can write the September $5 put options for around $55 per contract. That leads to two potential outcomes. First, the puts could expire and I'd be left with just that income. At more than 10% in just a few months, it's quite a payout. That being said, if I am assigned shares I'd be able to buy SandRidge for $4.45 a share which is less than its 52-week low. That's a win-win proposition if you ask me – earning healthy income or buying a stock below its 52-week low would both be terrific outcomes.  

Source: SandRidge Energy

Another company I'm looking at is Chesapeake Energy (NYSE: CHK  ) . Like SandRidge it's been weighed down by debt as the bursting of the gas bubble forced an expensive transition from gas to liquids. However, things are looking up as the company is making very good progress in its turnaround plan. Further, a big cloud of uncertainty was recently removed as it finally announced a successor to its embattled former CEO, Aubrey McClendon. I think that the future looks very promising and Chesapeake's stock is one I am very interested in owning.

Again, I could just buy shares but there is the potential for a bumpy ride so I'm looking at using put options as my investment strategy to buy shares cheaper. In this case, the October $20 puts look appealing. Recently paying around $100 each, by writing these puts I would earn 5%, or potentiality buy shares for $19 each. That's a nice discount from what I'd have to fork over to purchase shares today, which is why I like writing puts. 

The final company that's on my list is natural gas producer Ultra Petroleum (NYSE: UPL  ) . Unlike Chesapeake and SandRidge, Ultra hasn't bet big on switching from natural gas to liquids. Instead, as a low-cost producer its focus has been on drilling profitable natural gas wells. The company made the decision to cut back on its growth plans and instead is investing within its cash flow. That strategy could make Ultra a big winner if gas prices improve further.

I think that writing puts would be the best way to purchase this stock because shares could be volatile if natural gas prices move lower. The September $22 puts caught my eye as these can be written for around $140 per contract. That equates to around a 6% yield, which leads to a potential buy price of $20.60. That's a pretty compelling price to purchase shares while a 6% yield over the next few months wouldn't be a bad consolation prize. 

As you can see, writing puts is a great investment strategy to learn. Other than the income, this is a strategy that takes advantage of volatility by removing some of its sting, because you really have many ways to win when you write puts. However, before you begin your journey writing puts, let me just remind you of the three key takeaways:

  1. You must be willing to buy the stock at the strike price. 
  2. The payment received needs to be worth it.
  3. You're biggest risk could be missing the stock's upside. 

That final takeaway is one that you can't neglect. If you'd be disappointed by missing a stock's upside then a put is not worth the risk. Instead, look at writing puts as an investment strategy to either begin a new position on a stock trading higher than you want to pay or even to add to a position. For these reasons and more, writing puts is, in my opinion, the one investment strategy you simply must learn. 

Finally, of the three companies I mentioned, the one that I find most compelling right now is SandRidge Energy. The company is really focusing on growing its liquids production, its fundamentals have really improved and its puts pay very well. There are many other reasons why I think its future looks optimistic so if you'd like to learn more about the future of this emerging oil and gas junior and are looking to find out more about its strengths and weaknesses, then check out The Motley Fool's premium research report detailing SandRidge's game plan and what to expect from the company going forward. To get started, simply click here now!


Read/Post Comments (5) | Recommend This Article (8)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 30, 2013, at 4:17 PM, csqrd wrote:

    This strategy works great for those of us who use it on stocks we want to end up owning. A few additional thoughts on this strategy.

    If you're just starting, read the great introduction to options available on the Motley Fool site. My apologies but I don't recall who the author is but it will lead you through the terms and really help you to understand how options work.

    It helps you to get the best deal if you make a little table: Strike price, Premium for selling the PUT, Discount price, Exercise Return (what you get if the option is exercised), and discount from current price. For a stock with a current price of $5, and a premium of $5.50 at a strike price of $10 the table would look like this:

    $10, $5.50, $4.50, 122.2%, 10%.

    This might help you decide which strike price PUT to sell. This tells you at a glance that if the option is exercised (always a choice of the PUT buyer), you are able to buy the stock at a 10% discount to today's market price. If the option expires and you get to keep the premium, you made 122% on your money (the $4.50 per share). Whether I'm working out of an account where I need to write covered PUTs (reserve my cost in cash) or an after tax account with margin (sell the PUT without having to reserve money), I like to calculate the return on my eventual cost per share. It keeps me more conservative.

    The other trick I would recommend is to make a simple 2 dimensional plot of the probable outcomes. With your return on the vertical axis and the stock price on the horizontal axis, it's easy to see the possibilities. a 45 degree line through $5, today's price, shows what you gain or lose as the stock price changes. A parallel 45 degree line through the discount price, $4.50, shows your gain or loss if the option is exercised. When this line hits the strike price, draw a horizontal line. This shows your gain if the option expires.

    An understanding of this simple chart will greatly increase your confidence in selling PUT options because you control everything but the underlying stock price. If you want to increase your odds of ending up with the stock, sell at higher strike prices. If you want to increase your potential discount, sell at lower strike prices realizing that you may just end up with money instead of stock.

    I join Matt in urging all long term investors to learn this strategy and wish you the best of luck in your choices.

  • Report this Comment On May 30, 2013, at 5:51 PM, wjcost wrote:

    I have tried selling naked puts and covered calls. The downside of naked puts is you may end up buying a stock you thought you wanted to own for a price higher than it now is worth because bad news has come out. The trouble with covered calls is you may wind up selling a very good stock for a small profit, much less than it is now worth, after good news is announced. It is very hard to make a profit on options because the transaction costs, particularly the bid-ask spread, eat you alive. Have patience, buy good stocks an hold them.

  • Report this Comment On May 30, 2013, at 6:03 PM, mrconnors0531 wrote:

    Would it be more prudent to wait until the first expiration after earnings release therefore cutting down your premium price.

  • Report this Comment On May 30, 2013, at 6:06 PM, mrconnors0531 wrote:

    I do agree with wjcost it's a $5 stock, heck I've spent more that that on a call option in the money.

  • Report this Comment On July 29, 2013, at 8:26 PM, Terikan wrote:

    This is a horrible strategy actually. You either set yourself up for big losses, hedge out profits by using spreads, or write puts so far OTM as to stay safe that you also only earn a tiny % on the collateral (margin) you have to have available with your broker.

    It sounds great, but the result is almost always bad.

    A. You make a small amount of money for the risk you put on.

    B. You don't ever own the great stock as it takes off.

    C. You get stuck with a stock who's dynamics have changed from sounding great, to being horrible.

    C is what will happen if you employ this strat regularly. Either due to FDA regulation, political BS, CEO scandals, a horrible earnings report, or a bunch of idiot analysts tearing down the company.

    And if you are naked put and the stock goes down 20 dollars below your put, you are out 2k per contract. Oh yay, I bought the stock for 5 dollars cheaper than it was a week ago.

    A put spread can be used to decent effect if you choose the right strikes.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2458416, ~/Articles/ArticleHandler.aspx, 8/21/2014 4:21:10 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement