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As you can see in the chart below, shares of small-cap Molycorp (NYSE: MCP), a development stage company that engages in the production and sale of rare earth oxides, have been hit hard during the past two years. They have plummeted from over $77 in May 2011 to an all-time low of $5.07 made today, a staggering 93% decline.
As of this writing, MCP is trading around $5.20. Cheap is a relative term, but with downside risk of zero and unlimited upside potential, I think MCP stock qualifies.
If you are comfortable holding on to this inexpensive stock to wait for a potential recovery, then selling put options could allow you to collect income while you wait to get into the stock at a 10% 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.
This strategy has the same mathematical risk profile as a covered call. With put selling, there is an obligation to buy the stock at the 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 put options.
Rule One: Only sell puts on stocks you want to own.
The intention of this 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 options 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 every month on put sales 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 MCP April 5 Puts at $0.30 or better.
This cash-secured put sale would assign long shares at $4.70 ($5 strike minus $0.30 premium), which is about 10% below MCP's current price, costing you $470 per option sold. Remember: Only sell this put if you want to own MCP stock at a discount to the current price. If you are assigned the shares, a May covered call can be sold against the stock to lower your cost basis even further.
If the stock does not fall below the strike price before expiration, then you keep the premium you collected, essentially getting paid not to buy the stock.
As a die-hard value investor, I struggled with its valuation in the past, but now I'm ready to pull the trigger.
Following a breakdown, there are simply too many bearish technicals on its chart to ignore.
As bearish trends take hold, this pick has become an overpriced company in a struggling sector.