If you've been investing for any length of time, you will certainly experience the frustration of watching a stock run up before you get a chance to buy it. To take the sting out of that situation, there is a way to receive income -- with no money down -- to set the price you're willing to pay for that stock.
The one that got away
Let's imagine you've been watching Dean Foods (NYSE: DF). You think the company's mix of branded and private-label dairy products will hold up well if the economic recovery stalls. Unfortunately, the stock is up 29% over the past three months and you let it get away from you. At just under 17 times forward earnings, you think the valuation is now a bit rich for your blood.
What to do now? You’re interested in owning shares of Dean Foods, but only if you get them at a discount to current prices. In this situation, you can sell puts on Dean Foods stock with a strike price near the price you're willing to pay for the shares. Let me explain what that means.
Understanding put options
Put options give their owner the right to sell you shares at a predetermined price (the "strike") on or before a fixed date (the "expiration" date.) With Dean Foods stock at $12.50, you go ahead and sell puts on the stock with a strike price of $10 expiring in December. For every option you sell, you receive $0.40 in premium. When the options expire, two situations are possible:
- The stock price is above $10. The puts expire worthless. You keep the $0.40 in option premium, for an implied yield of 6.4% on the price of shares at the inception of the option trade.
- The stock price is below $10. The puts are exercised, and you buy Dean Food shares at the strike price of $10. Your cost basis of $9.60 per share ($10 less the premium you received upfront) is a 20% discount to the price at the outset of the option trade. By selecting the strike price of the options you sold, you decided what your cost basis would be if the puts were exercised, so it's a price you're comfortable with.
This is a win-win proposition: You know what the possible outcomes are in advance, and both suit you. In the following table, I run through the same numbers for six more stocks belonging to defensive sectors -- health care, consumer staples, telecommunications, and utilities.
|
Company |
Sell |
Recent Price |
Implied Yield/ Implied Cost Basis* |
|---|---|---|---|
| Lorillard (NYSE: LO) |
Dec. '11 $80 Put |
$109.60 |
5.8%/ $76.80 |
| CenterPoint Energy (NYSE: CNP) |
Nov. '12 $15 Put |
$18.60 |
4.0%/ $14.75 |
| CVS Caremark (NYSE: CVS) |
Jan. '12 $30 Put |
$37.16 |
3.9%/ $29.27 |
| Frontier Communications (NYSE: FTR) |
Jan. '12 $6 Put |
$7.77 |
3.2%/ $5.86 |
| Pfizer (NYSE: PFE) |
Dec. '11 $17 Put |
$20.10 |
3.8%/ $16.62 |
| Philip Morris International (NYSE: PM) |
Dec. '11 $55 Put |
$67.83 |
2.4%/ $54.20 |
*The implied yield is annualized and doesn't account for transaction costs. Source: Yahoo! Finance.
Not a free lunch
Here's a different scenario. Imagine that you had sold puts on Enron. Before the puts expire, the news breaks that the company is a house of cards. The stock collapses, and at expiration, you're forced to buy shares at the strike price. Unfortunately, the new information has dramatically altered your estimate of what the shares are worth, and you're no longer happy about paying the strike price for them.
That's an extreme example, but the point is that business values and estimates of value aren't static -- the price you're willing to pay for shares today may not be the same as the price you're willing to pay three months from now. To mitigate that risk, I think it's preferable to sell puts only on stocks of companies with low business risk -- like the ones in the table. Or you could delegate the choice of companies and option strategies to Jeff Fischer, the advisor of Motley Fool Options, a service in which he's compiled an amazing record of consistent gains. Of the 30 completed trades at May 31, 29 of them were closed at a profit.
A risk-free step toward options success
If you'd like to learn more about adding low-risk option strategies to your portfolio, give Jeff your email address in the box below and you'll receive, at no cost or obligation to you, the Options Insider Playbook. You'll also get access to three videos in which Jeff discusses option strategies and an invitation to a live, interactive Q&A session in which Jeff and the entire Options team will be available to answer your questions. This should be an easy decision: What's the downside to learning about a new tool for your investor toolkit?
