In short (no pun intended), I am opening an option to sell a stock I do not own. These "naked puts" pay me cash on the first day to accept an obligation to buy a stock in the future at a predetermined price. If the stock is one cent or greater below the strike price, it gets "put to me" and I have to cover the position by buying the shares pledged.
These options are available on any trading day but the position always closes out on the third Friday of the month. If the stock price closes out above the strike price, then the option expires.
Most investors will not receive approval to make these trades and that approval is required in advance in writing from your brokerage house. I have made and lost money doing this, but in a volatile market it is a way of buying stocks cheap by leveraging the fear in the market. I do not suggest anyone but the most experienced investors consider such a thing. Furthermore, I only recommend you do this with stocks you want to own anyway.
Here are two examples of recent trades and why I made them. The market is full of fear for plenty of good reasons and I have been following some high-quality stocks, hoping to get a bargain.
Recently, I did buy a few shares of United Parcel Service (NYSE: UPS) at $44.00 per share about the time I posted Chasing Value: United Parcel -- forgotten blue chip. I had sold my previous holdings near its 52-week high of $75.08 and I wanted to get back in, and did. The stock is a tremendous value in my mind, with great cash flow, recurring revenue, fuel prices way down, great management and balance sheet and to top it all off it is paying a 3.8% dividend yield at Fridays closing price of $44.84.
I wanted to buy more UPS and had an open order at $40 to acquire more shares. This is below the 52-week (all-time) low of $41.40. In reviewing available options, I found that there were April $40 'puts' offering $1.35 a share. This meant that two months from now I would have an obligation where my break-even position was $38.65 or 6.5% less than the all time low for UPS, paying over a 4% yield -- and below the strike price for my open order! I made the trade and took the cash.
I made a similar trade for Johnson and Johnson (NYSE: JNJ) getting paid $1.90 a share for April $55's. JNJ has all the characteristics of UPS, plus it is more diversified, AAA rated, and remains one of the few companies nobody is afraid of with a 26% return-on-equity even in these bad times. It is simply down on sales of index funds by investors seeking liquidity and safety from the unknown.
I will be expanding further on these types of trades in future stories, but I must emphasize to all my readers that I only recommend this if you would be delighted to own the stock at the given stock price anyway. When you can do this, you are basically picking up money in the street. In the case of UPS and JNJ you are also adding quality, long-term positions to any portfolio.
Sheldon Liber is the CEO of a small private investment company and the principal for design and research at an architecture & planning firm. He writes the columns Chasing Value and Serious Money. Disclosure: I own shares of JNJ and UPS and have open options in both as well.