Over the last few weeks, I have been having a harder time finding stocks that I am willing to recommend to my newsletter subscribers. My process for selecting the stocks I recommend has three components to it—fundamental analysis, technical analysis, and sentiment analysis. Ideally, I find companies with strong fundamental indicators that aren’t overly loved by other investors. As a contrarian, I want a little bit of bearish sentiment as the pessimists can turn bullish and help push the stock higher.
I am finding plenty of stocks that meet my fundamental requirements and I can still find enough of those stocks with strong fundamentals that have enough bearish sentiment to suit my needs. The problem I’m having right now is the technical picture. So many stocks have rallied by 50% or more since hitting lows in March and the weekly overbought/oversold indicators are in overbought territory.
While overbought stocks can still move higher, I find it more appealing to buy after a little pullback or when the stocks are in oversold territory. The gains tend to be more explosive after making a reversal from a downward swing.
With this somewhat unique problem right now, something I have started recommending to subscribers is writing put options against stocks that I want to own at a lower price. If you aren’t familiar with writing puts against an underlying stock, let me explain the process to you.
In order to write options you have to have an options account and you have to have a margin account. By writing put options, you are agreeing to buy the underlying stock at a specific price (the strike price) by a specific date (the expiration date). By writing or selling the put options, you collect a premium at the beginning of the transaction and then you wait.
To give you a real example, I recommended selling the August 65-strike puts on Lumentum Holdings (Nasdaq: LITE) earlier this week. At the time the stock was trading for $77.81, or almost 20% higher than the strike price. The options were selling for $2.25, or $225 for each contract sold. The margin required to sell these options was $875 and that gives us a return on margin of 25.7% ($225/$875).
Because we are obligated to buy the stock for $65 as long as the trade is open, we want the stock price to stay above $65. If it does and these options expire worthless, we made a 25.7% return on our money. If the stock drops below $65 and the shares are put to us, we are obligated to buy 100 shares of stock at $65 for each contract we sell. In this case, we would need $6,500 free to buy those shares. But now our cost basis for the stock is $62.75—the strike price minus the premium we collected.
Essentially there are three possible outcomes for this type of trade. First, the stock moves higher and never gets near our strike price and the options expire worthless. Second, the stock drops, but as long as it doesn’t drop over 20%, the options still expire worthless and we keep the $225 we collected in premium. The third outcome is when the stock drops below the strike price and we are forced to buy the shares. Now we own a quality stock that has dropped by 20% in less than two months and is likely oversold.
I am okay with any of those three outcomes for the Lumentum trade. The company has strong fundamentals and there is bearish sentiment toward the stock. The short interest ratio is currently at 6.28, that’s way higher than the average stock and indicative of bearish sentiment.
If you are going to employ the strategy, there are certain things you want to keep in mind. Personally, I won’t write puts on a stock that I don’t want to own. The fundamental analysis has to meet my requirements before I will even consider writing puts against the stock. Secondly, you will have to have cash free to make the purchase should the stock drop below your strike price.
If you write puts and the stock starts falling, you can always buy the options back any time before August 21. The price of the options could be lower or higher and that will affect the return on the investment, but you aren’t stuck in the trade for two months—in case you change your mind. To give you an idea, I recommended writing these options on June 29 with the stock trading at $77.81. It’s now July 2 and the stock has jumped to $83.11. The options are now trading at $1.50. I could recommend buying them back and we would have a gain of $75, but I don’t want to do that.
This put-writing strategy is one that I feel is underutilized. Right now option premiums are higher than usual due to the elevated volatility levels. Rather than sitting and waiting to see if Lumentum falls down to the trend line on the chart, my subscribers could get a return of over 25% to sit and wait. Personally, I like that kind of return.