Gad: Three Stocks Ripe for Selling Puts

There are two benefits to selling a put: generating income and providing the option to buy shares at a lower price. To actually benefit from these two conditions, one condition must be met for put-selling to work: you must -- I repeat must -- be comfortable owning the underlying stock.

Selling a put requires the seller of the put option to agree to take delivery of the underlying stock at the agreed upon exercise price within a specified period. If that exercise price is not reached during the option window, the premium is pocketed. If the exercise price is reached, then the put-seller must buy the stock at the exercise price and keep the put-premium, thereby reducing the actual cost basis in the underlying stock.

A few stocks meet the above the criteria and are on my list of put-selling candidates.

Probably the most attractive is Dell ( DELL). The shares now trade for around $10.50, a new 52-week low, and less than 6x forward earnings. Shares are being priced as if the company has no future, but the exact opposite is true. Dell is slowly transforming from a seller of PCs to a provider of enterprise software solutions to businesses and government. On top of that, the company is buying back loads of stock, announced an $0.08 per share quarterly dividend, and has committed to returning 20% to 25% of its free cash flow to shareholders each year. You can sell the Jan. 13 $10 puts for about $0.75 today. If exercised, your effective cost will be $9.25 a share: buying the shares at $10 but keeping the $0.75, (less commissions of course). Owning Dell at $9.25 would be an outright steal for patient investors. A name like Dell should not be trading for 6x earnings -- even a conservative 10x earnings multiple on the same earnings power creates a $17 share based on fiscal 2013 EPS estimates of $1.70. It's a win-win bet: Either keep the premium or get to buy a ridiculously cheap company for even less.

Next up is another tech bellwether, Hewlett-Packard ( HPQ), now trading at just over $17, or 1x book value. Book value is not a good measure in the industry but that's because margins and return on equity are so high relative to net asset value. You can sell the Jan. 13 $16 puts for $1.25 a contract. If exercised, you own HP shares for a net cost of $14.75 per share against book value of $16 per share. Otherwise, you collect the premium in four months.

Another wonderful play is Chesapeake Energy ( CHK), trading around $19. Sell some puts and either get paid to wait or own shares alongside the likes of Carl Icahn and Mason Hawkins in a business that is perhaps worth $40 a share accounting for the value of its gas assets, many of which are being monetized slowly.

There is one drawback to selling puts in these companies. Because they are ridiculously cheap, put-selling eliminates upside gains. If you sell the $10 puts on Dell, for example, but shares climb to say $15 or so, you've pocketed the put-premium but lost all the upside gain. Still, if your consolation prize for missing a huge gain is pocketing a small gain, you really haven't lost at all. Done for the right reasons, selling puts can often be a win-win trade.
At the time of publication, Gad had no positions in the stocks mentioned.

Sham Gad is the managing partner of Gad Capital Management, a value-focused investment firm based in Athens, Ga. Gad has written extensively for The Motley Fool and was a securities analyst for UAS Asset Management, a small value investment fund in New York City, in 2007. From 2002-2005, Gad managed assets for the Gad Investment Group.

Additionally, Gad has just released a new book, The Business of Value Investing: Six Essential Elements to Buying Companies Like Warren Buffett. He earned his BBA and MBA at the University of Georgia. Gad appreciates your feedback; click here to send him an email.