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Wednesday, August 6, 2014 - 13:45
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Wednesday, August 6, 2014 - 13:45

Fear and Uncertainty Create Opportunity for 30% Return in This Blue Chip

Wednesday, August 6, 2014 - 1:45pm

Shares of General Motors (NYSE: GM) were hit hard last month after the company missed analysts' revenue expectations for the second quarter. The company reported earnings of $0.58 per share -- which actually came in above consensus projections -- but the 1% increase in automotive revenue raised a major red flag for investors.

The day before General Motors released its Q2 numbers, the stock closed at $37.40. Today, investors are able to pick up shares at a 10% discount to that price. On a positive note, it appears that the stock may have found support as the stock hit a new post-earnings low on Friday, followed by a rally on Monday.

While the disappointment in revenue is certainly worth taking note of, it is fair to say that General Motors has faced some tremendous challenges over the past few months, mainly relating to recalls of vehicles with faulty ignition switches. The bad press the company has received is certainly weighing on the company's ability to sell cars, and yet GM was still able to post a year-over-year increase in automotive sales.

Following the 10% decline in share price, it is possible that GM has reached a point where the bad news has been fully priced into the stock and the "weak holders" have been shaken out. With the company's $1.20 annual dividend (giving shares a 3.6% dividend yield) and cash per share pegged at $18.57, GM now looks like a potential value investor target.

My expectation is that the strong dividend yield and healthy cash position will help to attract investors at the current price point. This should have the effect of laying a floor under the share price, likely keeping GM from dropping below $33. From this point, any positive news regarding acceleration in sales or even just a lull in the recall publicity could spur investors to move back into the stock -- ultimately pushing the price higher.

The good news for us as income investors is that the turbulence surrounding GM has helped to push the price of option contracts higher. Since we generate income by selling put options, their higher price works to our advantage.

Today, I want us to consider selling the GM Sep 34 Puts, which are currently offered near $1.55. The stock has been moving around a bit (which causes the premium prices to fluctuate), so I recommend using a limit of $1.20 to ensure you get a fair price for the contracts.

By selling these puts, we are taking on the obligation to buy 100 shares of GM per contract at the $34 strike price if the stock is trading below this level when the puts expire on Sept. 19. For taking on this responsibility, we are being paid $1.20 per share ($120 per contract) in option premium (or possibly more if you get a better execution). To cover this obligation, we will need to set aside $3,280 of our own capital, in addition to the $120 in premium.

The good news for us is, since we are receiving $1.20 per share from selling the put contracts, our net cost for the shares of stock would be $32.80 -- below the recent low and also below the floor where I expect GM to find support. I would be happy to own shares of GM at this price given the healthy dividend yield and potential for shares to rebound.

A more likely scenario, however, would be for shares of GM to rally between now and our September expiration. If shares close above $34 on Sept. 19, our obligation will expire worthless and we will get to keep the $120 in income free and clear. This income represents a 3.7% return over the $3,280 in capital that we set aside. Since the puts will expire in 45 days, our per-year rate of return is nearly 30%.

Using the volatility and uncertainty surrounding General Motors, we are able to use our put selling strategy to set up a very attractive entry point for the stock, with the potential for generating a very lucrative income yield if the stock rebounds. This is a classic example of contrarian trading: capitalizing on fear and uncertainty and using the scenario to set up a high-probability income trade.

Note: My colleague Amber Hestla has closed 52 straight winning trades using this strategy. You can see her entire track record and learn exactly how you can make the same winning trades yourself by following this link.​

Zachary Scheidt does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.