One of the most dangerous endeavors that individual investors and “wannabe” traders can engage in is options trading.
Stock and index options bring with them a degree of leverage and time restrictions that have the capability to blow up an account in pretty short order, something that happens on a pretty regular basis. It is hard enough to pick stocks that go up, but to do so in a fixed time frame is even more difficult. To top it off, if you pick the wrong strike price you can get the direction and timing right and still lose money.
The individual trader is trading against large institutions with pricing, modeling and trading capabilities that are far beyond their own. All too often the retail trader's role in the options market is to provide lunch money for the trading desks and market makers.
Start With A Company's Business Valuation
There is a way that individual investors can use options to earn higher returns and add to the overall return of their current portfolio. This strategy takes advantage of the fact that most option traders think only about the value of the option and not the value of the underlying business.
At the same time, most value-oriented investors are not fans of options, as they view it as a high-risk leveraged trading activity. We can take advantage of these two groups' lack of interest in each other's strategy to use options to enhance a value portfolio.
Rather than starting with the option valuation and trading price of the underlying security, we are going to start with the business valuation of the underlying company. Using a deep-value orientation, investors should focus on those stocks trading at or below book value.
Stay With The Cheap And Safe
We know from academia and the real world that stocks purchased below book value tend to outperform the market over time, so we are starting our project with a slight edge. You also want make sure the company's balance sheet has a margin of safety, and the company has the financial strength to keep the doors open and the lights on for the foreseeable future.
Focusing on safe and cheap stocks that you are happy to own at the strike price is what makes this approach as close to a true win-win as you will find in Wall Street.
Once we have identified a stock that is safe and cheap, we simply want to sell cash-secured put on the stock. You want to put up the cash required to purchase the stock at the strike price, and not just the minimum margin required by your broker and the exchanges.
On many value stocks you will have fair-sized spreads in the option price, so learn to use the valuation calculator at CBOE.com to determine where to place your limit orders to sell the option.
If the stock goes down and you are exercised on the put, you own safe and cheap stocks at the strike price, less the premium. If the stock price stays the same or moves higher, you keep the premium. As long as you did the valuation work correctly and are happy to own the underlying stock, either outcome is a win.
As an example there's MFC Industrial (MIL), a commodity supply chain company with a merchant banking division that invests in natural resources-related assets. The stock is currently trading at about $7.50 a share, which is 70 percent of book value, so it is a bargain. They have plenty of cash on hand to keep the bills paid, and the debt-to-equity ratio is just 0.32, so there is a margin of safety in the balance sheet.
The October $7.50 puts are currently quoted at $0.25 bid and $0.45 offered. The fair value is about $0.33, so you can place an order to sell the puts at that level. That is a premium of 4.4 percent, which is yours to keep if it is executed. Annualized for the two and a half months until expiration, it's a return of 21 percent.
If the stock is above $7.50 at expiration, you keep the money and can sell a new position if you choose. If the stock goes down, you buy the stock at $7.50 less the premium you received for selling the option.
This is meant as an example only, as all these prices will be different by the time this article is posted.
Investors who start with valuation of the underlying company and then sell cash secured puts can add several percentage points to their annual returns by backing into positions selling cash-secured puts.
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