On July 30, I recommended a cash-secured put strategy in Facebook (NASDAQ: FB) in which traders sold Facebook Aug. 22 puts for $1. This setup was meant to allow traders to buy Facebook at a 10% discount from where it was trading at the time, or get paid not to own it by collecting a premium if the stock did not fall below the option's strike price.
Shares ended up being assigned to us when prices finished below $22 at expiration on Friday, Aug. 17. The cost basis for the shares was $21 ($22 strike minus $1 premium), a level at which we were comfortable and prepared to buy the stock.
And when you take into account the $1 premium we collected from our July put sale that expired in our favor worthless, the cost basis would be lowered to $20 per share, which means we bought Facebook for less than half of its all-time high at $45.
Although the share price has declined even more since expiration, Facebook can be viewed as a long-term investment. Each option sold represents 100 shares, which means $2,000 per option contract originally sold is committed based on the discounted basis cost.
The first objective of any investor should be to control risk. If you can quantify and know the worst-case scenario it is possible to evaluate any trading candidate. For this Facebook trade, the worst-case scenario, albeit unlikely, is that the share price goes to zero and the $2,000 is lost.
More often than not, investors focus on reward potential when risk control is the most important money management factor for long-term success. Simply put, trading is about probability, and you should never enter into a play that could limit your ability to participate in opportunities another day.
That said, some people incorrectly assume the cash-secured naked put strategy carries more risk than it actually does. Selling a put, with the intention and full funds to own the shares, is essentially a limit price below the market price plus a discount in the form of the option premium received. In fact, this strategy has the same mathematical risk profile as a covered call, which brings me to my next trade setup.
Facebook covered call strategy
High-volatility stocks are potential covered call picks because the option sold, while it limits the upside profit potential, lowers the cost basis of the stock. The caveat that most ignore is that, like a cash-secured naked put, a covered call should only be employed if you are prepared to own the stock long term. The premium received is a small allowance if the stock has a major negative move.
The advantage of using a put sale to buy a stock we want at a discount is amplified by the use of the covered call strategy later. We can continue to sell covered calls each month to lower the share price until the stock is called away.
Action to Take --> Sell to open Facebook Sept. 21 calls for $1 or better.
Selling a $21 strike call again lowers the cost of owning the shares by $1 to $19. If Facebook is above $21 at expiration on Sept. 21 and we are called out, a $2 difference is banked and the play is closed. A $200 potential profit is a respectable 10.5% return on a $1,900 investment for a position held for only a few short months.
If Facebook is not above the strike price at expiration, we will hold the shares and sell an October covered call to again lower the overall cost basis.