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.
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 (NASDAQ: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:
- You must be willing to buy the stock at the strike price.
- The payment received needs to be worth it.
- 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.
Fool contributor Matt DiLallo has no position in any stocks mentioned. The Motley Fool recommends Ultra Petroleum. The Motley Fool owns shares of Ultra Petroleum and has the following options: Long Jan 2014 $20 Calls on Chesapeake Energy, Long Jan 2014 $30 Calls on Chesapeake Energy, Short Jan 2014 $15 Puts on Chesapeake Energy, Long Jan 2014 $30 Calls on Ultra Petroleum, Long Jan 2014 $40 Calls on Ultra Petroleum, and Long Jan 2014 $50 Calls on Ultra Petroleum. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.