Whenever I can determine that a stock has been priced below its intrinsic value, I have the option of simply buying that security or selling a cash secured put that will get me in at my chosen price or pay me for waiting. Selling puts will not guarantee that you'll become a shareholder of that company, but the strategy will pay you for waiting to see.
The difficulty with determining whether a stock is below it's intrinsic value. Fundamental analysts will look at future estimated revenues and earnings and calculate P/E ratios and PEG ratios. They'll look at debt, return on equity and profit margins to see if they're increasing or decreasing. And they'll look at product cycles. They may look at numerous fundamental factors and determine inherent value and if its less than the current price they'll declare it undervalued and issue a buy.
Technical analysts will look at the various technical indicators. They'll look for over bought or oversold areas on a price chart and try to determine if the price is about to reverse. Most technical analysts use, at a minimum, the RSI and the MACD but there are dozens of others available. Contrary to fundamental analysts, technical analysts generally won't determine the inherent value of a security but instead simply look at the direction that traders are pushing a stock. They let the traders determine if a stock is overvalued or undervalued and simply buy or sell based upon the price activity of the security.
For those who are unfamiliar with cash secured puts, here's a nice review.
Cash Secured Puts
Selling cash secured puts is a tactic I use in order to bring income into my account other than my own hard earned cash. I also use this strategy to enter a position at a price below the currently quoted price and at a price more appropriate to the underlying value of the stock itself. Similar to call options, a put option is, at its core, simply an option contract. It's derivative in nature and it’s value exists in its contractual obligation between the buyer and the seller. It’s also considered a long position and is therefore related to buying (going long) stock.
The cash-secured put involves writing an at-the-money or out-of-the-money put option and simultaneously setting aside enough cash to buy the stock. The goal is to either be assigned and acquire the stock below today's market price or to collect the premium income for use in later trades.
When an investor is bullish on an underlying stock he can sell a cash secured put and hope for a temporary fall in the price of the stock. If it falls below the strike price, the put will most likely be assigned and the put would buy the stock at the strike price less the premium received.
What are the Risks?
One possible risk is that the stock may fall significantly below the strike price and the investor will be locked into a loss at assignment. Any investor in this situation must be comfortable prior to selling the put with being assigned the stock at the strike price.
Another possibility is that by waiting for a price dip for entry, the investor may miss out on a stock that continues to climb upward. Subsequent decisions would obviously repeating the short put strategy or closing out and buying the stock outright.
What kind of Investor Sells Cash Secured Puts?
This is primarily an income producing or a stock acquisition tactic for a price-sensitive investor. As a stock acquisition tactic, the goal is to collect the premium income and then acquire the underlying stock by assignment at a strike price less the premium received.
Unfortunately the assignment of stock is not guaranteed. If the stock’s price remains above the strike prior to the expiration of the option, the stock will never be purchased. The result would be pocketing the premium received for the put.
What is the Maximum Loss?
The maximum loss is limited but substantial. The worst that can happen is for the stock to become worthless. In that case, the investor would be obligated to buy stock at the strike price but the loss would be reduced by the premium received for selling the put. The maximum loss, however, is lower than it would have been had the investor simply purchased the stock outright.
What is the Maximum Gain?
The maximum gain from the put option itself is limited to the premium received at the time of sale. Gains in addition to the put option may include gains received after assignment when the stock appreciates in value. The best scenario would be for the stock to dip slightly below the strike price at the put option's expiration, trigger assignment and then rally immediately afterwards to record heights. The put assignment would have allowed our investor to buy the stock at the strike price minus the premium just in time to participate in the following rally.
What about Time Decay?
The passage of time will have a positive impact on this strategy, all other things being equal. As expiration approaches, the option tends to move toward its intrinsic value, which for out-of-money puts is zero. If the original forecast and goals still apply, the investor keeps the premium and is free to either buy the stock outright or write a new put.