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How to Sell Put Options for Income

Let’s walk through an example of how to sell a put. After careful selection of the right stock, you decide you would like to create a monthly income stream by selling puts each month on this stock. Let’s say the stock is currently trading at $70 in the market. After reviewing the option chain, you decide to sell the 67.5 put option on this stock that expires in one month. The 67.5 strike price is out of the money and will obligate you to buy the stock at $67.50 only if the put buyer decides to exercise the option on or before the expiration date. The put buyer will only exercise the option if they make money or if the stock price is below $67.50.

As the put seller (writer), you get to collect the cash premium for the option. In this case, let’s assume it is $200 per option contract or 100 shares of stock. The investor now has a risk of $67.50 – $200 = $65.50 per option contract sold. If this amount of $6550 per contract is in the investors brokerage account, this is a cash-secured put. The potential return is $200 which the put seller will keep regardless of the trade outcome.

The investors return is calculated as $200/$6550 or 3.05%. This is a nice return on a one month put option. On an annual basis, this is a return of 36.6%! This is why I sell put options for monthly income.

Here are the details of the trade:

1 Option = 100 Shares of Stock: In this example, we sold 1 put option. In other words, we sold someone the right, but not the obligation, to sell 100 shares of stock to us for $67.50 on or before the option’s one-month expiration date (usually the 3rd Friday of the month).

$ 2 = Our Options Premium: In exchange for giving someone (the put buyer) the right to sell us 100 shares of stock at $67.50, we get paid in cold-hard cash! In options lingo, we get paid in the form of a premium. In this example, our premium is $ 2 per share. Because each options contract equals 100 shares of stock, here our premium is $ 200. This $ 200 is deposited in our account at the time of the transactions. It is ours to keep no matter what transpires before expiration (the end of the contract).

There are 2 potential trade outcomes:

  1. The stock prices stays above the 67.5 option strike price so the put option expires worthless. Put yourself in the position of the options holder (the person that buys the put option from us). The put holder purchased the right, but not the obligation, to sell 100 shares of stock at $67.50 per share. Assume this put option expires in one month. If, at the end of that one-month expiration time period, the stock is trading at a price above $67.50, why would the put holder exercise his right to sell the stock at $67.50 when he can sell at a price above $67.50? They would not exercise the put option! The investor keeps the $200 premium and has a 3.05% return in one month.
  2. The stock declines in price and is below the 67.5 option strike price. The option will be exercised and the shares of stock will be sold to us at the strike price ($ 72.50 per share). Again, put yourself in the position of the put holder for a moment. If, at the time the put option is set to expire, the stock is trading at $65, and the put holder has the right to sell shares of stock at $67.50, why wouldn’t the put holder exercise his right to sell the stock at $67.50 per share? They would. So in this scenario, the cash we previously deposited into our brokerage account ($6750) is used to purchase the underlying shares that were “put” or sold to us. Our break-even point, also referred to as our “cost basis,” is now $65.50 ($67.50 per share we paid for the stock less the $ 2 per share put premium we received from the original sale of the put option). At this point, we own 100 shares of stock and can sell them or write a covered call trade.

This is a simple example of how to sell (write) a put option for monthly income. Once we do this each month we create a stream of cash flow to help us achieve financial independence.

Last month, we were successful on all put trades and averaged 3.5% return for the month.  Imagine making $3000 or more in income each month!   Start making more income each month by subscribing to the Monthly Income Plan.

HFC pays 8th Special Dividend and Boosts Regular Dividend by 50%

Investors looking for a regular helping of special dividends should consider HollyFrontier Corporation (NYSE: HFC). The company just announced its 8th special dividend since August 2011.  In addition, HFC just juiced its regular dividend by 50%.

Subscribers to my Get Rich Monthly Income Plan received $31.00 per share in dividends in 2012 with a yield on cost of 12.5% in one year.  In addition, subscribers received $1,690 in call premiums on each 100 shares of HFC stock in 2012.  The covered call premiums accounts for a yield of 68% as subscribers utilized a special income technique called the perpetual covered call.  In total, Monthly income Plan subscribers booked a total return of 219% on HFC in 2012 alone!

HollyFrontier Corporation (HFC) announced today that its Board of Directors approved a 50% increase in the Company’s regular quarterly cash dividend to $0.30 per share from the current rate of $0.20 per share. This is the fifth increase in the regular dividend since the merger in July of 2011, representing a total increase of 300%. The regular dividend will be paid on April 2, 2013 to holders of record of common stock on March 15, 2013.

The Company also announced today a special cash dividend in the amount of $0.50 per share. The special dividend will be paid on March 19, 2013 to holders of record of common stock on March 5, 2013. This is the 8th special dividend declared by HollyFrontier since August 2011.

HFC’s stock price is up 70% in the past year but still trades at a low PE of 7.5 which is a 60% discount to the industry average PE ratio.  HFC has an equity summary score of 9.8 out of 10 for a VERY Bullish outlook.

Mike Jennings, CEO and President of HollyFrontier, said, “Our Board of Directors remains committed to delivering value to our shareholders through both a growing regular dividend as well as special dividends. After today’s 50% dividend increase, our current regular dividend yield is 2.2%, and our trailing twelve month cash dividend yield stands at 6.1% relative to today’s closing price of $53.72. Including today’s announcement, HollyFrontier has returned almost $1.3 billion in capital to shareholders through regular dividends, special dividends and buybacks since the July 2011 merger.”

Chevron Is Right For This Option Strategy

Chevron Corporation, through its subsidiaries, engages in petroleum, chemicals, mining, power generation, and energy operations worldwide. It operates in two segments, Upstream and Downstream.  CVX has an equity score of 9.6 (VERY BULLISH) out of a 10.  This is a covered call position on Chevron Corp (CVX),

OPTION STRATEGY:

Look at the June 95 covered call. For each 100 shares of Chevron Corporation (CVX) stock you buy, sell one June 95 covered call option for an 96.70 (100.30 – 3.60) debit or better. That’s potentially a 3.4% assigned return.

STOCK TREND:

The technicals for CVX are bullish with a weak downward trend.  The stock is under distribution with support at 101.95.  S&P rates this stock 5 STARS (out of five) – strong buy.

RESEARCH NOTES:

S&P maintains strong buy recommendation on shares of Chevron Corp. (CVX) . CVX sees ’12 capex at $32.7B, up from $28B, before acquisition, expected in ’11.  Upstream is slated at $28B (87%), with major capex at LNG and deepwater projects.  We think it will comfortably fund this plan, and possibly boost dividends and buybacks via projected cash flow.  We see CVX thriving from a smaller refining footprint, where Asian exposure will help future results.  About 69% of production is higher-margin oil.  Shares have outperformed peers and benchmarks in ’11, but discounted valuations and solid near/long-term growth visibility remain highly attractive, in our view.

Covered Write on American Tower (AMT)

American Tower Corporation (AMT) is a holding company. It is a wireless and broadcast communications infrastructure company that owns, operates and develops  communications sites. Its primary business includes leasing antenna space on multi-tenant communications sites to wireless service providers and radio and  television broadcast companies. This business is its rental and management operations. The Company also offers tower-related services domestically,  including site acquisition, zoning and permitting services and structural analysis services, which primarily support its site leasing business and the addition of new tenants and equipment on its sites. On August 6, 2010, the Company’s, Transcend Infrastructure Limited, acquired Essar Telecom Infrastructure Private  Limited (ETIPL). On June 29, 2010, it acquired 113 towers from Telefonica Chile S.A. As of December 31, 2010, the Company acquired 475 towers from  Telefonica del Peru S.A.A.

This is a covered call trade for monthly income using AMT as the underlying stock.  AMT has a neutral equity score of 5.8 in a 10 point scalle by analyst covering the stock.

OPTION STRATEGY:

Look at the January 2012 59.65 covered call. For each 100 shares of American Tower Corp (AMT) stock you buy, sell one January 59.65 covered call option for a 57.19 (58.69 – 1.50) debit or better.  That’s potentially a 4.3% assigned return.

STOCK TECHNICALS:

The technicals for AMT are bullish with a weak upward trend.  The stock is under accumulation with support at 57.67.  S&P rates this stock 5 STARS (out of five) – strong buy.

RESEARCH NOTES:
S&P maintains strong buy opinion on shares of American Tower (AMT) .  AMT announced it plans to acquire roughly 2,500 towers from Telefonica’s (TEF) subsidiary inMexico, Pegasos PCS, for roughly $500M.  We view the planned deal as a positive as it roughly doubles AMT’s exposure to Mexico and these towers should benefit from the recent spectrum auctions and the launch of new technologies.  We believe this also demonstrates AMT’s desire to remain in a growth mode while also looking to achieve REIT status. We maintain our 12-month target price of $74, based on 24X our ’12 free cash flow estimate, a slight premium to peers.

 

Selling Time Value of Options

When selling time value, you will use a different philosophy than those stock investors looking for a stock to go up in price.  Your gains will come from the time value of the options you will sell.  This approach to stock selection is unusual.  Most investors use fundamental analysis or technical analysis while you will use the time value of s stock’s options, tempered by fundamentals and long-term hold principles.

Deciding to create a covered call trade requires choosing an expiration month and strike price.  Option strategies require making modifications during the life of an option trade.  The option expiration month you select will have significant impact on the success of any option trade.

There are at least four different expiration months available for every stock on which options trade.  Initially, the CBOE set up only four months for options but later LEAPS were introduced so it was possible for options to be traded for more than four months on stocks with LEAPS options.  When stock options first began trading, each stock was assigned to one of three cycles: January, February or March.  Stocks assigned to January cycles will offer options in the months of January, April, July and October.  The same quarterly sequence will hold for the February and March option cycles.  Under the new rules, the first two months are always available but for the later months the original option cycles are used.

To select a stock for your covered call portfolio, you must have available a current option chain list.  You can select the expiration month based on the time value of the stock options and the strike price.  Then, if the stock meets your stock selection criteria, but it as the underlying stock in your portfolio.

To get an annual return of 20% or more, you must find available options with time value that will produce a 2% return each month or 5% each three months on the price of the stock.  Using the option chain list, you can calculate the percentage of stock price that the time value represents.  Of all the optionable stocks, you can find at least 5 to 10 stocks to consider.  If the time value seems attractive, then look at the fundamental and technical analysis to make your decisions.

Personally, I like to sell an option in the current or next month with a time value return of no less than 3%.  However, I will caution all covered writers
to proceed with caution if the time value return is very high as usually there is something pending with the underlying stock such as a news event, earning
release and other items.  Volatility can play a significant role in the pricing of options so the higher priced time value options usually have a significantly higher volatility.

What Option Open Interest Means to the Trader

Option open interest is the number of options contracts open in a specific option series.  Open interest serves as a measure of option liquidity in the underlying option series.  The higher the open interest, the tighter the bid/ask spreads will be so slippage in trades will be lower.  When looking at option series, you want to be sure open interest is at least 5,000 and that the bid/ask spreads are no larger than 20 point apart.

When net buying or selling occurs in the underlying security, the open interest will show this change in the same direction of trader moves.  Increases in call open interest indicate the underlying is advancing up while increases in put open interest indicate more selling pressure.

Here are some rules on how to interpret open interest levels for OTM calls and puts in relation to the stock’s price movement:

  • Growing OI in Calls – confirms strength of stock’s advance
  • Declining OI in Calls – bearish divergence of stock’s advance
  • Flat OI in Calls – slightly bearish as no additional support for stock advance
  • Growing OI in Puts – confirmation of stock’s decline
  • Declining OI in Puts – slightly bullish as no additional support for stock decline
  • Flat OI in Puts – slightly bullish as it is not confirming decline

The growing interest in OTM and ATM options will confirm the stocks continued movement in the same direction.  Basically, this means the traders who have
been right are still buying more options for continuing the same direction.  In comparison, when open interest falls it indicates that traders are leaving the trade so it will likely end the current movement.  Traders are taking their money off the table.

The chart below displays a put/call open interest chart for Salesforce.com (CRM).  Notice how the blue line has been declining from 1.25 down to 0.95.  This indicates the number of puts are declining while the calls are increasing.  The traders are starting to turn more bullish on CRM as its stock price (red line) has increased to $125.

Put/Call open interest chart for CRM - getrichinvestments.com

Click to enlarge

Support and Resistance levels for the Covered Call Writer

One of the keys to covered call writing success is knowing how to determine support and resistance levels.  A support level is a stock price low that the price has hit and recovered from to advance back up due to more buying than selling of shares.  This is referred to as the trading floor until a stock price breaks below it.  The resistance level is a higher level that the stock price has hit and pulled back due to more selling than buying of shares.  This ceiling acts as resistance that the stock price must break through to advance higher.

The more times the price has hit a support or resistance level, the stronger it is and more difficult to move through it.  The longer it takes for the stock to test
these levels, the stronger they are to break through.  For example, an intraday test is not as strong as a one week test of these levels.  The higher the stock volume at the level, the stronger the level is holding.  For example, if volume is above average and the stock price doesn’t break out then the level will hold and be more difficult to go through.

Most technicians draw the support and resistance levels at the lowest and highest price points on a stock chart.  If stock price reached a certain support or
resistance level multiple times, you can safely disregard a single price spike above or below these levels.

How can the covered call writer use these support and resistance levels.  If a quality stock has successfully tested the support levels, then you know where the price bottom is for that stock.  You can also use the support level to tell you when to react as a break below support requires a new decision on what to do with your covered call – close it, roll out, etc.  The other use of support and resistance for the call writer is to delay entering a new trade when a support or resistance level is being tested.  These price points should be watched closely to see if they hold.  If they do not hold, then be prepared to make
a decision on managing the covered call trade.

Covered Call Write on Advanced Auto Parts

Covered Call trade on Advanced Auto Parts (AAP).

OPTIONS STRATEGY:

Look at the December 2011 70 covered call.  For each 100 shares of Advance Auto Parts (AAP) stock you buy, sell one December 2011 70 covered call option for a 67.06 (69.31 – 2.25) debit or better. That’s potentially a 4.38% assigned return.  This stock also pays a dividend which may add another 0.1% to the return. The stocks last ex-dividend date was 9/21/2011.

TECHNICALs:

The technicals for AAP are bullish with a possible trend reversal.   The stock is under distribution with support at 64.38. S&P rates this stock 5 STARS (out of five) – strong buy.

RISK:

For those wanting downside protection, buy the March 2012 65 put for 3.50.  Sell the put when you exit the covered call.  This is optional for the covered call to protect the downside of AAP at 65.

RESEARCH NOTES:
S&P reiterates strong buy recommendation on shares of Advance Auto Parts (AAP) .   For the 12-weeks ended October 8, EPS of $1.41, vs. $1.03, is $0.22 above our estimate.   While comp-store sales rose just 2.2%, this quarter lapped an exceptional 9.9% increase in the year-ago period, providing a challenging hurdle.   We continue to favor industry fundamentals, and expect global sourcing efforts and supply chain investments to drive improved gross margins over the medium term.  As a result, we are increasing our ’11 and ’12 EPS estimates to $4.96 and $5.71 from $4.72 and $5.47, and are also raising our DCF-based target price by $5 to $85.
EARNINGS HIGHLIGHTS:
  • On 11/09/11, the company announced quarterly earnings of 1.41 per share, a positive surprise of 19.4% above the consensus 1.18.  Over the past 4 quarters, the company has reported 3 positive (>2%), 1 negative(<-2%), and 0 in-line (within 2%) surprises.  The average surprise for this time period has been 5.0%.
  • AAP’s current quarter consensus estimate has remained relatively unchanged over the past 90 days at 0.68.  Estimates within its Subsector have moved an average of 0.0% during the same time period.
  • During the past four weeks, analysts covering AAP have made 1 upward and 0 downward EPS estimate revisions for the current quarter.

Calendar Spread Trade on Noble Corp (NE)

A CALENDAR SPREAD that involves selling the January ’12 37 call and buying the January  ’13 33 call should cost $32.59 less per share than the covered call and potentially yield a 100% return if the stock stays above $37 through expiration

TRADE:  Noble (NYSE: NE) ended the last trading session at $37.79.  So far the stock has hit a 52-week low of $27.33 and 52-week high of $46.72.  NE has had an S&P 4 STARS (out of 5) ranking since 6/8/2010.  On 7/21/2011 S&P equity analysts set a 12-Month price target of $47.00 for the stock.   Noble stock has been showing support around $36.76 and resistance in the $38.52 range.  NE is part of the S&P 4 STARS stock list.  One way to play this stock would be with a calendar spread that substitutes a longer term call option in place of the covered call stock purchase.  To use this strategy consider going long the NE Jan ’13 33 Call and selling the Jan ’12 37 call for a $2.00 debit.  The strategy has a 75 day life and would provide 7.38% downside protection and a 100.00% assigned return rate for a 486.67% annualized return rate (for comparison purposes only).

RISK: The Calendar spread strategy will normally carry more risk than a covered call strategy, but the rate of return is generally higher, since there is a lower capital outlay.  At a 3 Key risk ranking this strategy is considered to have moderate relative risk.  If the stock price at expiration is below $37 this strategy will not generate the potential returns shown. Another risk for this strategy is related to the bought Call Option price.   If the stock drops in price between now and
expiration date, there is a possibility that the Jan ’13 33.00 call could drop quickly.

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