why not just sell 2 naked puts.

Discussion in 'Options' started by Free Thinker, Jan 29, 2010.

  1. this author is making it too complicated. even though it looks like he has constructed a complicated combo trade with a good return in reality all he is doing is selling 20 naked puts. comments.

    http://seekingalpha.com/article/184...total-return-with-a-coca-cola-buy-write-combo


    Coke (KO) shares need no introduction. This high quality, good yielding issue has dipped with the market from a recent high of $59.45 to finish yesterday at $54.14/share. EPS hit an all-time high in 2008 and are expected to have come in slightly higher for 2009 once Q4 earnings are released.

    KO garners Value Line’s highest ratings for financial strength, safety, stock price stability and earnings predictability. They also have the approval of an obscure investor named Warren something or other.

    Here are Coke’s historical per share numbers from continuing operations as reported by Value Line: Year
    Sales
    C/F
    EPS
    Div.
    B/V
    Avg. P/E

    2002
    7.92
    1.99
    1.65
    0.80
    4.78
    30.2x

    2003
    8.62
    2.31
    1.95
    0.88
    5.77
    22.6x

    2004
    9.12
    2.45
    2.06
    1.00
    6.61
    22.6x

    2005
    9.75
    2.59
    2.17
    1.12
    6.90
    19.7x

    2006
    10.39
    2.81
    2.37
    1.24
    7.30
    18.5x

    2007
    12.45
    3.08
    2.57
    1.36
    9.38
    21.0x

    2008
    13.82
    3.58
    3.02
    1.52
    8.85
    17.8x

    2009*
    13.10
    3.60
    3.05
    1.64
    10.40
    15.9x



    * 2009 data includes Q4 estimates

    At yesterday’s close of $54.14 KO shares trade for < 15.8x the 2010 consensus estimate of $3.43 making the present multiple near the lowest of the past 20 years. The dividend is now 3.03% based on last year’s payout.

    A rebound to even a 17.5x multiple on forward estimates would bring KO shares back up to above $60 by year-end. That would be a 10.86% rise from here. Add in the yield and 13% - 14% seems like a conservative 12-month target.

    Is that reasonable to expect? Value Line is using a 21 multiple for their 3 – 5 year projections. Standard and Poors now carries a 12-month goal of $65/share while assigning KO their highest, 5-star rating. Morningstar has a ‘consider selling’ price of $68.80/share.

    KO shares hit peak prices of $64.30 - $65.60 in 2007 – 2008 and touched $59.45 pretty recently.

    While Coke does not seem to have home-run potential it does seem a good bet to creep higher as its earnings and dividends grow over time. The longer the time period the surer you might feel that KO shares will be higher than yesterday.

    Under that scenario here’s a nice two-year play that could generate outstanding total return with a pretty low risk profile. Cash Outlay
    Cash Inflow

    Buy 1000 KO @ $54.14 /share
    $54,140

    Sell 10 Jan. 2012 $60 Calls @ $3.10 /share
    $3,100

    Sell 10 Jan. 2012 $60 Puts @ $11.20 /share
    $11,200

    Net Cash Out-of-Pocket
    $39,840



    If Coke shares merely rise to $60 or better (+10.8% from yesterday’s quote) by Jan. 20, 2012:

    The $60 calls will be exercised.
    You will sell your shares for $60,000.
    The $60 puts will expire worthless.
    You will have collected at least $3,280 in dividends.
    You will have no further option obligations.
    You will end up with no shares and $63,280 in cash.
    That best-case scenario would result in a cash-on-cash profit of $23,440/$39,840 = + 58.8% achieved on shares that only needed to rise by < 11% over the next two years.


    What’s the risk?

    If coke shares fail to break above $60 by the Jan. 20, 2012 expiration date:

    The $60 calls will expire worthless.
    The $60 puts will be exercised.
    You will be forced to buy another 1000 KO shares.
    You will need to lay out an additional $60,000 in cash.
    You will have collected at least $3,280 in dividends.
    You will end up with 2000 shares and $3,280 in cash.
    What’s the break-even on the whole trade?

    On the original 1000 shares it’s the $54.14 purchase price less the $3.10 /share call premium = $51.04 /share.

    On the ‘put’ shares it’s the $60 strike price less the $11.20 /share put premium = $48.80 /share.

    Your overall break-even would be $49.92 (excluding dividends) and $46.64 (including the yield).

    KO shares could fall by as much as (-13.8%) without causing a loss on this trade.

    Summary:

    Conservative, good-yielding KO shares look good for decent returns over the next couple of years with only a modicum of risk.

    The buy/write combination seems likely to outperform the straight purchase of shares and provides a 13.8% margin of safety in case of unexpected market action
     
  2. If I skimmed this right, he's buying the stock, selling covered calls, and selling puts.

    Covered calls ~> naked puts.

    So he's effectively selling puts and then selling more puts.

    Cool.

    Probably why he writes about trading instead of actually trading.
     
  3. You'd think that if an author is reaching for an audience more sophisticated than a pumpkin (discussing naked puts), he'd have a clue about the synthetics. Other than that, his numbers add up.
     
  4. i emailed him about it. just got his explanation. the tax treatment is better:

    "The tax treatment is quite different. On the actual share purchase you can get long-term gains while collecting dividends at the reduced tax rates they command.

    If you short two puts instead and they expire worthless your gains are 100% short-term regardless of how long you had the position in place since you never had a 'holding period'. "
     
  5. That is true because when you sell the put you are collecting the dividend upfront in the options premium.
     
  6. i did not know this since i have never held a naked put for a year but i did some research and it is also true that a naked put is taxed as short term gains no matter how long you hold it if it expires worthless.
     
  7. Taking an unlimited-downside, limited upside position for "tax treatment" reasons is, IMO, a rather stupid idea.
     
  8. If that's the case then selling the puts isn't the brightest thing to do. One should do all CC's and gain favorable tax tretment on the entire position.

    I'd expect his response to that to be along the lines of "If one doesn't have the capital to purchase 2,000 shares then the puts enable one to take the larger position." Then I'd say that one has no business selling puts if one doesn't have the capital. And round and round we'd go ... :)

    FWIW, I'd still go with all NP's despite the tax treatment. Fewer commissions and less slippage. The tax angle is worthless if the position goes south :)
     
  9. I don't think he's touting the position because of the tax treatment. However, I whole heartedly agree that CC's and NP's have a lousy risk/reward ratio and one had better be good directionally if one is going to bite into that.
     
  10. I'm sure you are correct. Buying a bunch of shares of "safe" KO probably will fly better with his readership than selling a bunch of "risky" puts naked. How many threads have been on ET about people trying to "capture" dividends. This seems like a variant of that strategy.
     
    #10     Jan 29, 2010