Buying Stocks with Naked Puts

Using Naked Puts is a strategy I employ quite often. First, however, we need to know the definition of a Put and, more importantly, why is it “naked.” For a detailed explanation of both, you can click here.

Again, using Kellogg (K) as an example:

From the chart on the left, we can see that Kellogg’s price is hovering around the $50.00 range — or at the top of its price range. And, yes, I realize that the company’s stock is  down approximately 15% from its high on 5/13/2011. Some would say this is a great buying opportunity, and others would say the stock price still has further to fall. Personally, I’m inclined to believe it could still fall further; and, with that in mind, I would be willing to put (pun intended) on an options trade to try and get into the stock at a more favorable price.[private]

Here’s what I would do: I would place a sell order for the June 2012 45 Put at a price of $0.55. If the order is filled, I will collect $55.00 in premium and put the money aside (along with an additional $4,445.00) for the purchase of 100 shares of Kellogg at a price of $45.00 per share. If, by June 15, 2012 (equity options expire on the third Friday of every month), Kellogg’s stock price is at $44.99 (or less), I will end-up buying 100 shares at a price of $45.00 per share. Effectively, however, I will actually be purchasing the shares for $44.45 per share because of the premium dollars I took-in when I sold the Put option (45.00 – 0.55 = 44.45).

Now for a few notes: First, the above information assumes that the buyer of the Put does not exercise the Put prior to the expiration date. The buyer has the option of “putting” the shares to the option seller (i.e. exercising the option and forcing the Put seller to purchase the shares) when the stock price reaches $45.01 (or lower) prior to the expiration date. Second, if Kellogg’s stock price drops below $45.00 per share (let’s say to $35.00 per share) you are still required to purchase the shares at the $45.00 per share price (unless, of course, you are willing to buy the Put back for, undoubtedly, a loss). And, finally, none of the above information takes into consideration broker commissions and/or fees.

Also, a cautionary note is warranted here: You should never sell Puts without putting money aside for the purchase of the shares. In other words, never, ever, enter into a naked Put position on margin (i.e. with borrowed monies from your broker), or without the cash necessary to cover the Put — it’s simply too dangerous!

The reason I like this trade so much is because I feel confident in the companies whose shares I am looking to purchase. That is, I would not mind buying shares of a dividend paying company like Kellogg at a lower price than that which is currently offered. Also, if the stock’s price does not dip to $45.00, and I do not end-up entering into a position, I get to keep the premium (i.e. the $55.00) I took-in when I sold the Put. AND, if I do end-up purchasing the shares, I will view the $55.00 premium as an additional dividend payment, which, in this case, increases the annual dividend yield by 1.2% (55.00 /45.00 x 100 = 1.2%).

So, though risks are involved, I view the naked Put strategy as having an acceptable risk/reward ratio. In either case, I get to keep the $55.00 premium; and, if I end-up purchasing shares of Kellogg, I feel I will be entering into a position with a good company that pays a decent dividend, and one that is considered a defensive investment.

Note: Chart and options information taken from optionsXpress.

Disclaimer: No positions in Kellogg at the time of this writing.[/private]

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