Earn Income While Waiting to Buy an Already Inexpensive Stock at a 17% Discount

After lagging the broader market for more than a year, SPDR S&P Metals & Mining (NYSE: XME) finally put in a bottom in June and has bounced more than 30% from those lows.

Cliffs Natural Resources (NYSE: CLF), a major supplier of iron ore, fell from $100 a share in 2011 to below $20. Shares hit a 52-week low of $15.41 in July, around the same time XME’s uptrend began. CLF then rallied 88% to a high just below $29 in November before selling off.

Currently trading near $18.70, support sits below at $16. The $20 level is a long-term price pivot point and represents resistance CLF must overcome on a monthly closing basis to reverse the downtrend.

If you are comfortable holding on to this inexpensive stock for a potential recovery, then selling puts could allow you to collect income while you wait to get into CLF at a 17% discount.

Cash-Secured Put Selling Strategy

While the typical investor might use a 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 option.

[ad#Google Adsense 336×280-IA]This strategy has the same mathematical risk profile as a covered call.

When selling puts, there is an obligation to buy the stock at the option’s 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 from selling the puts.

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 traders must follow to be successful at selling puts.

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

The intention of the put selling 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 the option’s strike price if a sell-off occurs. 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 each month from selling puts 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 CLF May 16 Puts at $0.40 or better. (Be sure to select the options expiring May 17, and use a limit order to get the desired level of income.)

This cash-secured put sale would assign long shares at $15.60 ($16 strike minus $0.40 premium), which is about 17% below CLF’s current price, costing you $1,560 per option sold. If the put option expires worthless, you keep the $40 premium, earning a potential 2.6% return in 30 days.

Remember, you should only sell this put option if you want to own CLF at a discount to the current price.

If you are assigned the shares, a June covered call can be sold against the stock to lower your cost basis even further. If CLF does not fall below the strike price before expiration, then you keep the premium you collected, essentially getting paid not to buy the stock.

— Alan Knuckman

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Source: ProfitableTrading