Volatility Makes Beaten-Down Stock an Attractive Discount Trade

The recent bounce in volatility, a cost component in an option‘s price, has made premium-selling strategies more attractive. After new five-year lows in the CBOE Volatility Index (VIX) in mid-August, this measure has jumped 35% since the beginning of October to the highest level in a month and a half. Simply put, traders want to buy options when volatility is low and sell options when it is high.

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Arch Coal (NYSE: ACI) has been in a serious downtrend, falling from above $35 in 2011 to a decade-plus low in July at $5.16. Around $8 currently, the basing formation on the chart has a near-term target of $10, and a longer-term objective of $12.50, the halfway resistance of the $20 high to $5 lows.

For those traders who are comfortable holding this seemingly inexpensive stock to wait for a potential recovery, an options selling strategy can help you potentially get in at an even lower price… or get paid not to.

Cash-Secured Put Strategy

While the typical investor may use a straightforward limit order to buy a stock or ETF at a designated price or lower, the options trader can do one better by selling a cash-secured put.

This strategy has the same mathematical risk profile as a covered call. With the put sale, there is an obligation to buy the stock at the strike price if it is assigned, allowing you to get into the stock at a discount. In fact, the true entry cost basis is even lower with the subtraction of the premium you earned when selling the put.

And if the stock is not below the strike price at expiration, then the premium received is all profit. In other words, you’re getting paid not to own the stock.

There are two rules that cash-secured put traders must follow to be successful.

Rule One: Only sell puts on stocks you want to own.

The intention of this strategy is to be assigned the stock as a long-term investment (each option contract represents 100 shares). So make sure you have the funds in your account to buy the stock at a discount if a sell-off continues. Paying in full ensures that no additional money is needed to hold the stock for potentially many months or even years until a price recovery.

Rule Two: Sell either of the front two option expiration months to take advantage of time decay.

Collect premium every month on put sales until you are assigned shares at a cost reduced basis. Every month that you keep the premium is money subtracted from your entry price.

Recommended Trade Setup: Sell to open ACI Nov 8 Puts at $0.50 or better.

This cash-secured put sale would assign long shares at $7.50 ($8 strike minus 50-cent premium), which is about 6% lower than ACI’s current price, and would cost you $750 per contract. Remember: Only sell this put if you want to own ACI shares at a discount to the current price. And if the stock does not fall below the strike price, you keep the premium you collected, essentially getting paid not to buy in at a discount.