Fri Mar 23, 2007: Subprime Covered Puts (NFI, LEND)

Dead-cat bounces in some of the sub-prime mortgage lenders like Accredited Home Lenders Holding Co. (NASDAQ-LEND) and NovaStar Financial, Inc. (NYSE-NFI) offer the possibility of high percentage returns from shorting the stocks now and selling covered put options.

This is a bearish strategy. You are betting the stock goes down or stays approximately the same. If it goes up you can lose money.

With the stock currently at $5.81 per share, a May 5 put option on NFI can be sold for 1.30, or $130 per contract on 100 shares. This would provide an option income for approximately two months of 44.8% assuming the stock is unchanged through expiration Friday May 18th, and assuming your broker requires a 50% margin deposit of $290.50 to sell the stock short. 130 / 290.50 = .448 or 44.8%.

If the stock falls below 5, the put holder would exercise their option to put the stock to you, that is, to sell it to you, at $5 per share, which would actually generate an additional profit for you since you sold it short at $5.81 and would automatically buy it back at $5.00. In that case your total return would be 72.6%. Remember we're ignoring commissions in these examples.

Charts of NFI and LEND

With LEND stock currently at $11.77 per share, a May 10 put option can be sold for 1.65, or $165 per contract on 100 shares. This would provide an option income of 28%.

If the stock falls below 10, the put holder would exercise their option to put the stock to you, that is, to sell it to you, at $10 per share. In that case your total return would be 58.1% due to an additional profit of $1.77 per share on the stock.

Importantly, remember that if the stock goes up your potential loss is unlimited, and you could be subject to a "margin call" requiring you to deposit additional money in your investment account to cover the loss.

Until next time, best of luck with your option investments!