Naked Puts - a tool for the value investor or for those seeking interest like returns?

Reading an article this morning reminded me of an investment technique
which in some cases might be intriguing to the value investor.

http://www.futuresmag.com/Issues/2010/May-2010/Pages/Naked-put-vs-covered-call-Whats-riskier.aspx

This may be a meaningful concept to the value investor to sell naked puts on the stock you want to hold at the right price.

Lets say you have determined WAG is a value stock, you want to hold, but you would prefer to buy it at 33 rather than the present price of 35.20 and your analysis of the chart indicates a reasonable probability that you might have that opportunity in the not too distant future.

Instead of putting in a limit buy order to buy the stock at 33, sell a naked put. For this example sell a July 10 Put with 33 strike for $.83. For each contract you sell, you will collect $83 minus commissions. At some brokers, this could be as little as $1 or $2.

If WAG rises instead of dropping, you might consider buying your put back when it is considerably cheaper. The value will also drop as it gets closer to expiration.

At or anytime before expiration, if the stock should drop below $33 the stock can be assigned to your contract and you will own the stock at $33, but actually you will own it at $33-$.83

Of course you must consider commissions and assignment charges at the broker.

Also whether you are willing to have the capital to purchase the stock tied up without having the potential for upside.

If the stock never drops to you strike price in this example assuming $80 after commissions you will pocket 2.48% for tying up $3300-$83 for 59 days'

What is the downside risk? The market severely drops and the stock follows. Or the stock has very bad news and you really have a wrong estimation of value.

In that case you could end up with a stock at a price, at a price you are no longer happy with.

The other uncomfortable and possibly very uncomfortable area is if the stock drops to say $25. The purchaser of your put has no requirement to assign the put to you. Therefore, if you want out prior to expiration you will be faced with a very expensive put to buy back.

If today the stock dropped to $25 the put would be trading closer to $33-$25 or $8 plus possibly some minimal time value.

Meanwhile, you are locked in till stock is assigned to your put or expiration.

In either case, if the stock is below $33 when this event occurs you will be buying at $33. At some brokers this strategy can even be undertaken in an IRA with the proper permissions. Interactive Brokers is one of those. Please do not construe this blog as investment advice! It isn't! You are responsible for your own investments, research, and decision process leading to such. Best of Luck! Micro