Use Put Options To Buy Stocks At A Discount

By Timothy Green - September 10, 2012 | Tickers: GLW, FB, HPQ | 0 Comments

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Many investors keep a watch-list of stocks which they are interested in but may currently be a bit too expensive for their tastes. A common strategy is to simply place a limit order for a stock at the price which you'd like to pay and wait, hoping that the stock becomes cheaper. But what if I told you that there's a way to make a profit while waiting for the stock to fall? Instead of sitting on a pile of cash earning nothing you can sell cash-secured put options and collect premiums while you wait.

A put option has three components: the strike price, the premium, and the expiration date. The buyer of a put option is buying the right, but not the obligation, to sell 100 shares of the underlying stock at the strike price on or before the expiration date. If the buyer chooses to do this, the option is exercised and the seller is obligated to buy the shares. This may occur when the stock price falls below the strike price. The buyer pays the seller a premium for this right.

A common argument against using this strategy is that if the stock price falls well below the strike price the seller is forced to buy the stock at a price much higher than market value. This raises an important point: this strategy is only suitable if you want to buy the stock and are comfortable buying at the strike price. The alternative would be to simply place a limit order at the strike price, and in both cases the same paper loss would be suffered. But if you're buying the stock because it's undervalued, at a lower price it's even more undervalued. Now, if you sell puts only to collect premiums and have no desire to actually own the stock, chances are you will end up overpaying for a stock that you don't want. This is mainly a strategy to buy stocks with the added bonus of making extra money, not the other way around.

As an example of employing this strategy, I'll look at Corning (NYSE: GLW).

Valuing Corning

Before I talk about the options, let's roughly estimate the value of Corning. On the balance sheet there is $6.345 billion in cash, $4.870 billion in investments, and $4.2 billion in debt and debt-like obligations, including things like pension obligations. This leaves a net cash position of $7.015 billion, or $4.62 per diluted share. As of this writing Corning trades around $12 per share, so we immediately see that more than a third of the market capitalization is cash. I'll calculate owner earnings using the five-year average capital expenditures. Corning spent $2.4 billion in capex in 2011, which is much greater than in previous years. The five-year average is $1.5 billion. Using this figure owner earnings for 2011 comes to about $1.98 billion. Using a discounted cash flow analysis with a 15% discount rate and assuming growth to be just 3% going forward I estimate the value of a share of Corning to be $15 per share. This is a full 25% above the current market price.

Put Options

Given that Corning is undervalued, let's now look at the put options currently available to sell. Here is a list of put options with strike prices of $11, more than 10% lower than the current market price.

If you sell the Nov 2012 put with a strike price of $11 you receive a premium of $25. The cash needed to buy 100 shares of Corning, $1,100, is tied up until either the option expires or it is exercised. If the market price never goes below the strike price before expiration the shares are not put to you and you can write another put. The premium you received represents a 11.68% annualized return on the $1,100 investment. If the market price does dip below the strike price then you may be forced to buy 100 shares of Corning for $11 per share. This is fine, since Corning is undervalued and the goal was to buy Corning at a discount.

A Couple More Examples 

Typically stocks which are more volatile have higher option premiums. You can take advantage of these high premiums on stocks which you'd like to own. Let's take a look at two more stocks with lucrative put premiums: Facebook (NASDAQ: FB) and Hewlett-Packard (NYSE: HPQ).

Facebook  

Facebook stock has fallen off a cliff since the IPO, currently trading at $18.96 per share down from $38 per share at the IPO. A strike price of $15 gives you a 20% discount to today's price if the shares are put to you, and as you can see in the table below offers attractive premiums.  

Selling the Nov 2012 $15 puts on Facebook get you a 18.85% annualized premium and the chance to buy the stock at more than 20% less than the price today.

Hewlett-Packard 

HP stock has taken a beating lately, as questions about relevance and a bleak PC market continue to weigh down the company. the stock trades at $17.59 per share as of this writing, down from nearly $30 per share early this year. A strike price of $15 offers a nearly 15% discount to today price and is at a level not seen since 2003.     

By selling the Jan 2013 puts you receive an annualized return of 12.17% from the premium and have a chance at buying HP stock at a level not seen in nearly a decade.

Conclusion 

Selling put options in order to buy shares at lower prices allows you to collect premiums as you wait for the stock price to fall, instead of simply sitting on a pile of cash. Corning puts offer an annualized return of 11.68% with the possibility of buying shares at $11, significantly lower than my $15 fair value estimate. This offers a great opportunity to pick up shares of Corning at a bargain price. In addition to Corning, Facebook and HP offer attractive options premiums at strike prices well below the current market value.

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