Wed Feb 8, 2006: Coeur d'Alene Mines (NYSE-CDE) Naked Put Example

Some equity investors hope to make big profits buying stocks they expect will rise sharply over the coming months and years. They're looking for capital gains.

Others are income-oriented, willing to give up big potential gains in return for steady monthly income.

Currently, CDE options offer naked put writers a one-month yield of 7.5%. Let's take a look at the details and some of the risks involved.

For purposes of this example we'll ignore commissions and just consider a single option for 100 shares. Most option writers sell lower-priced options like this ten at a time, or more, so that the commission charges become less significant.

At today's closing price of 5.00 per share and a bid of 0.35 on the March 5.00 puts, these options can be sold for $35 each. Setting aside $500 in case the put option gets assigned, the percent income is equal to $35 divided by $500, or 7%. If assigned, the $35 received could be applied to the purchase price, so actually only another $465 would be required and thus the yield could be computed as $35 divided by $465, which is 7.5%

Most brokers allow, for margin accounts, a smaller amount of money to be set aside. Typically 30% of the stock price is required. This would make the theoretical yield much higher, but it would not provide enough money to purchase the stock if it closes below the 5.00 strike price on option expiration day Friday March 17th. In that case the put option writer would have to buy back the put before it expired, possibly at a loss depending on how far down CDE stock went.

By having the full $500 on deposit the naked option becomes a "cash-covered" option and there is no worry about not having enough money to pay for the stock should it be "put" to the option writer when the option buyer exercises their right to sell the stock at the strike price of 5.00 per share.

In the above case, the effective net cost to the option writer would be only $4.65 per share. For this reason, naked (or cash-covered) put option writers often speak of "buying stock only at a discount" (to the current price). They get to keep the option income regardless of what happens, whether the option expires worthless or not. If they are assigned, they end up paying less than the price was when they started. So they always buy the stock at a discount, or not at all.

If CDE stock is at 5.00 or higher on expiration day, the put option will expire worthless and the writer's obligation ends. Then he or she is free to sell another option for the next month using the same money set aside previously.

One frustrating aspect of this strategy is that if the stock soars higher in any one particular month, the profit for the option writer is limited to just the premium received, while others who purchased the stock outright score larger gains. But income-oriented option investors tend to be patient, leaving the big wins to others as they strive to consistently maintain a premium advantage and accept steadier although limited returns. In upcoming commentaries we'll be discussing many other option strategies.

In addition to an enticing yield, put option writers also try to select stocks of companies they expect to do well - stocks they will be happy to own anyway if they are assigned. For investors who currently believe that precious metals will be a popular investment for some time to come, CDE is one candidate for selection. However, as always, this is not a recommendation, just an example. Consult your professional investment advisor.

And best of luck with your option investments!