Diversify Your Investment Options

 | Jan 26, 2012 | 12:00 PM EST
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I want to revisit the subject of selling options to generate returns and as a method of backing into undervalued stocks. After the December rally through today, I find that a pretty good percentage of my short option book has expired worthless, so I am on the hunt for new ideas to sell some premium. As I mentioned in Tuesday's column, I am not in a rush to sell premium. I am finding the ideas and building a list of candidates for cash secured put selling when volatility picks up and prices move down. In some cases I am calculating the option price I want to collect and entering good to cancel orders but for the most part I am loading the gun before the shooting starts so I can act quickly and decisively when the time comes.

One stock that I own and have sold puts on two times in the past year is Callaway Golf (ELY). The earnings report yesterday was uninspiring but the market apparently like the guidance issued by management as the stock drifted up during the day. The company also showcased its new product line for 2012 including the new fully adjustable RAZR drivers. The big story with this stock is that golfers are not consumers -- they are addicts. As consumer confidence improves, we will see pent-up demand cause a sales explosion for Callaway products. Until then, if I can sell the May $6 puts for $0.50 or more and back into the stock below tangible book value, I think it is a good trade. This is one where I will go ahead and enter the good-'til-cancelled order and hope it hits.

 It is no secret that I like the regional banks for the long term, and I think selling puts is a great way to back into these stocks. I have sold options and been put shares of both Key Corp. (KEY) and Fifth Third (FITB) in the last two years and it has worked out very well. These stocks have shot higher in recent weeks, so we need to wait for a pullback in the market and sector to give us better option pricing, but both of those are my regional bank put-selling list. So are Huntington Bancshares (HBAN), Hudson City Bancshares (HCBK) and First Niagara (FNFG). I want to go out in the April-June period and collect as much premium as possible on these names selling one strike below tangible book value. If I am patient, I think it will happen.

TCF Financial (TCB) is another bank I like if the shares continue to move lower. TCB just reported a very weak quarter as it has been struggling to replace fee income it lost as a result of new regulations. Its profits dropped by more than half, year over year, and fell well short of analyst estimates for the fourth quarter. The stock trades right at tangible book value and the equity to asset ratio is about 8.4% so the stock is cheap enough to consider. If I can create a long trade by selling the April $9 puts for $0.45 or more I would be willing to do so.

Micron Technology (MU) is another stock that has I have back into by selling puts last year and I hope to do so again. The stock has rallied with the market and is now trading right at its tangible book value once again. As the global economy recovers, this stock has nowhere to go but up . The company is in some of the fastest growing segments of the chip market. Micron is increasing its focus on the higher-end flash memory market for mobile and tablet products and that should help drive bottom-line growth for the next several years. If the market gets a decent pullback and I can sell the April $6 puts for $0.40 or more, I would try to back into the stock by selling the options.

Keep in mind that when I sell puts, I like the stock at the strike price minus the premium collected and I am willing to be a long-term owner of the stock. I focus on stock valuation first, and only then price the options for decent trade. I also do not post exchange or brokerage margins but put up the full price of the stock. This may reduce returns on the capital I employ, but it also eliminates almost all of the risk related to selling options. The risk profile of a cash-secured put is exactly the same as a covered call. When done right, it can add several percentage points to your return for the year and is a valuable tool for value investors.

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