Shares of American icon Harley-Davidson (NYSE: HOG) have been on quite a ride this year.
The stock sold off on July 22, following the company's Q2 earnings announcement despite a solid beat on both the top and bottom line. Revenue rose 12% year over year to $2 billion, and earnings came in 34% higher at $1.62 per share. The Street had only been looking for EPS of $1.46 on $1.8 billion in sales.
Yet, the stock appears to have bottomed in early August, making a higher low versus its February low, and shares have begun to tick up. I think the downside has already been priced in at these levels. The company's share buyback program and stock's 1.7% dividend yield should also help put a floor under shares.
HOG currently trades at 14.6 times next year's estimated earnings of $4.38 per share, below its historical average P/E of 16.8. A fair value estimate for the stock's price based on 2015 EPS estimates and a P/E of 16 puts it at $70 a share.
We can use the recent volatility in HOG to our advantage by selling puts. On the chart, I added the 20-day price channel, which is a good gauge of how far the price shifts during that period. Higher volatility means higher option premiums, and as option sellers, this means we can generate above-average levels of income.
Specifically, I'm looking at selling the HOG Nov 62.50 Puts for a limit price of $2.
By selling these puts, we immediately generate $200 per contract and accept the obligation to buy 100 shares of HOG per contract at the $62.50 strike price if the stock is trading below this level when the puts expire on Nov. 22. If HOG appreciates as expected, our put will expire worthless, and we can pocket the $200 free and clear.
On the other hand, if HOG falls below $62.50 before expiration, we will be assigned shares at a net cost of $60.50 ($62.50 strike price minus $2 option premium). In other words, we will be buying a discounted stock we are bullish on at an additional 5% discount, and will not experience a loss unless shares fall below this level. HOG has not traded below $60.50 since August 2013, and it seems unlikely it will do so in the next three months.
However, in order to cover this potential obligation, we need to set aside $6,050 per contract of our own capital, along with the $200 we receive from selling the puts, as collateral. If HOG is above $62.50 at expiration and the contracts expire worthless, our $200 in income will represent a 3.3% gain over the $6,050 that we allocated to this trade. Since that will be generated over 86 days, our per-year rate of return nets out to 14%.
In this case, once the puts expire in November, as long as HOG hasn't risen to its intrinsic value of $70, we can continue selling puts to generate a steady income stream. And if we do end up owning shares, we still get an undervalued stock with a healthy dividend that should provide a generous return.
Note: Using this strategy, my colleague Amber Hestla just closed her 66th straight winning trade. You can learn more about her put selling strategy and see her first 52 trades here.
This article originally appeared on ProfitableTrading.com: This American Icon Took a Beating, but Now It's Back on Track