This is an excerpt from James Altucher's newsletter, TheStreet.com Internet Review. It was originally sent to subscribers on May 1 at 9:44 a.m. EDT. It's being reprinted as a bonus for TheStreet.com readers.
This will be the third month that I recommend a strategy of selling puts against the positions in the Internet Review portfolio. When we do this, one of two things can happen. In the first scenario, the stocks remain above the strike price of the options, the options expire worthless, and we pocket the money we get from selling the options. In effect, we are generating a little side income from our stock holdings. What's not to like about that?
In the second scenario, the stock falls below the strike price, giving the people who purchased the options the right to sell us shares at that price. If they do, we effectively get to average down on our holdings. I believe all of the picks in the portfolio are good values at current levels, so I'm happy to average down at even lower prices. In short, when you sell puts, you either make money (the premium you sell the puts for), or you average down at an attractive price. Either way, I'm happy.
This strategy is related to portfolio construction. When I initially enter a position, I make it only 1% to 2% of overall holdings because I'm not a believer in the focused portfolio idea of having, let's say, only 10 picks. I prefer 30 to 50 picks because one can significantly outperform the market this way.
I do leave room to increase the size of individual positions, usually to around 3% of total holdings, and I accomplish this through the put sales. The nice thing about these sales is that even if the puts expire worthless and I don't increase my stock positions, I still get a nice options premium and reduce my cost basis.
Below I discuss an example of what I'm talking about: a stock I highlighted in my Feb. 27 newsletter as being a candidate for a put sale, describing what actually happened.
: I suggested the March $25 puts, which were trading at 15 cents. The stock closed at $26.86 last Friday; the $25 puts would have expired worthless. You would have made $15 on each contract you sold (one contract is for puts on 100 shares). Right now the stock is at $27.49, and it doesn't look like there are any interesting (i.e., cheap) contracts to sell.
This week, a few "options options" for the Internet-savvy investor:
- Sell the May 2006 puts with a $25 strike price on Microsoft (MSFT) - Get Report. Although the stock now sits below the strike price, this tech giant has fallen too far, too fast. It's got a $1.10 premium.
- The second idea is more speculative than most. I would take a look at the July 2006 call options on EarthLink (ELNK) , specifically, the out-of-the-money $10 calls that are selling for 45 cents. EarthLink's new Helio service is coming out any week now, and the stock could spike on the news. This is ultraspeculative, but it may be worth a try. If the stock closes below the $10 strike on expiration day, May 19, I'm happy pocketing the 45 cents. If it closes at $10 or above (a 15% gain from here), I don't mind my shares getting called away because it's such a sharp gain in just two weeks.
- Sell the May 2006 $22.50 puts on Palm( PALM) for 85 cents. I remain bullish on Palm, and this represents an attractive investment opportunity.
- Sell the May 2006 $10 puts on RealNetworks (RNWK) - Get Report.
- Sell the E.W. Scripps (SSP) - Get Report $45 puts for 45 cents. This company is cheap at its current price and even cheaper at $45, so I'd be happy either owning it there or getting paid the premium if the stock doesn't fall below that level.
At the time of publication, Altucher and/or his fund was long ELNK, RNWK and CPRT, although positions may change at any time.
James Altucher is a managing partner at Formula Capital, an alternative asset management firm that runs several quantitative-based hedge funds as well as a fund of hedge funds. He is also the author of
Trade Like a Hedge Fund
Trade Like Warren Buffett
. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Altucher appreciates your feedback;
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