There's no doubt in my mind that many market watchers are keeping an eye on the volatility in energy shares and feeling intrigued by the opportunity to invest and reap an out-sized gain. There's also no doubt in my mind that carefully selected energy bets today will, indeed, deliver market-beating results.
For some investors who are willing bet long on energy and truly have the patience to ride out the volatility, selling put options on energy shares may be interesting, especially now.
With the market experiencing a lot of volatility over the past month, energy shares have been even-more volatile. Because a key variable in option pricing is volatility, premiums have become very expensive, thus making the sale of puts somewhat intriguing today.
Let's use Freeport-McMoRan (FCX) as an example. The copper and oil producer recently attracted Carl Icahn as an investor. You can sell the February 2016 $10 puts for around $2 a contract today, 20% of the strike price. By collecting the premium, you are obligated to buy shares if they fall to $10 or below, but your net cost would be $8 a share. Typically, however, the option may not be assigned unless shares fall below $8, which is what I will assume to continue with this example. Selling this put gives you $2 a share in pocket today, and you are contractually agreeing to buy 100 shares for $10 a share, or $1000. Since an exercise means you keep the option premium, your net cost is $800.
If assigned, you own Freeport at a net cost of $8 per share, so any seller of a put has to be willing to own the underlying stock -- as well as have the cash to settle the contract. If you think Freeport, which traded as high as $30 a year ago, is a good long-term bet, selling a put give you income now -- and a chance to own the stock later at a much lower price.
But here's the issue with selling puts on energy and commodity shares today: If the underlying shares move higher without triggering an exercise, you miss out on the upside. If you really want to capture the pure upside potential, then you must either buy the shares outright or buy a call option, understanding the risk that comes with it.
Given the murky outlook for the energy sector over the next several months, however, those who want exposure to certain energy names can sell puts on those names. If the shares decline, you have effectively reduced your share price by a significant amount. And if the shares don't decline further, you make out with a little income for your portfolio.
However, I cannot stress enough that selling puts on energy contracts should be made on businesses that have balance sheets or assets that you believe will navigate successfully through the turmoil. And if you wouldn't lick your chops at the opportunity to own already depressed equities at even-lower prices, selling puts should also be avoided.