Out-of-the-money (OTM) put premiums in Occidental Petroleum (OXY) are relatively high now and they look attractive to sell short for investors to gain additional income. This opportunity works for long-term investors who already own OXY stock.
I discussed the company's huge free cash flow (FCF) in my last Barchart article on Sept. 19, “Occidental Petroleum Looks Cheap Here Given Its Huge Free Cash Flow.” This led me to the conclusion that OXY stock was undervalued at 17x forward earnings and with its 1.09% dividend yield.
I also suggested that selling short the $64.00 strike price put options for expiration on Sept. 29 was attractive. The premium was 31 cents, giving the short put investor an immediate 0.48% yield with less than 2 weeks until expiration.
OXY stock closed at $64.88, so the price remained above the $64.00 strike price of the short put play. That means the investor would not have had to buy 100 shares of OXY stock at $64.00.
Shorting Near-Term OTM Puts
Now it makes sense to continue this type of near-term out-of-the-money (OTM) short put play. For example, the $60.00 strike price for the Oct. 27 expiration period trades for 57 cents. That is almost a 1.0% yield for short put traders with a 6% downside protection in less than 3 weeks.
This can be seen by dividing 57 cents by the $60 strike price (i.e., $0.57/$60.00 = 0.95%). If the investor can repeat the yield every 3 weeks for a year (i.e., for 17 periods), the expected return is over 16% (i.e., 0.0095 x 17 = 0.1615, or 16.15%).
Here is what this means on a practical basis. If an investor secures $6,000 in cash and/or margin with their brokerage firm, they can enter an order to “Sell to Open” 1 put contract at $60.00 for expiration on Oct. 27.
The account will then immediately receive $57.00, which won't ever be taken away. So, for example, if the investor secures $18,000, they can then sell short 3 put contracts. The account will receive $171.00. That works out to 0.95% of the $18K invested.
If this is done every 3 weeks for a year, the expected return could be $2,907 (i.e., $171 x 17). As a result, since the same $18,000 is used every time this is done, the total expected return for the year would be 16.15% (i.e., $2,907/$18,000).
Downside Risks
Now, not every time this is done, will the trade be successful. Sometimes the investor may have to purchase 100 shares with the secured cash. That could result in unrealized capital losses from time to time. But at least the investor will not be forced to sell any shares that they already own.
That is why this type of trade is good for an investor who wants to gain a bargain position in the stock on a dollar average cost basis over a period of time.
Keep in mind that this works well for long-term investors. They already earn the 1.09% dividend yield with OXY stock. As mentioned sometimes the investor's short put trades may result in the purchase of additional shares. This will allow the investor to earn more dividends.
In addition, over time the investor can sell out-of-the-money (OTM) call options as well to gain more income. That is another reason why this type of trade works well for investors who want to be long OXY stock.
On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
