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.
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
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.
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.