Monday, June 9, 2008

Using Puts to Pay at the Pump

I just returned from a week spent in America's Dairyland, and woke up today wondering what I was going to write about. Being out of the loop for a week has rusted my little grey cells, so I switched on CNBC in hopes of finding some inspiration. Lo and behold I happened to twig onto a short piece on options plays. One of the guests offered an interesting way that the consumer could subsidize his gas purchases by selling out-of-the-money (OTM) puts on Exxon-Mobil (XOM). That struck me as a droll idea and a fun way to get revenge on those “evil” oil companies. (I don't share the view that oil companies are all evil; the current high price of oil is more a result of speculation on the part of those “evil” pension funds and others.) So, how does this concept of put selling work and are there other oil sector stocks that we can use for our nefarious purposes?

Selling Puts
Let's recap our knowledge of puts. Buying a put option gives the buyer the right, but not the obligation to sell a stock (or a future) at a specified price called the strike price on or before the expiration date which is usually the third Friday of the expiration month.* In contrast, the seller of a put option assumes the obligation of buying the stock from the put seller at the strike price. Why is this an attractive investment? Because the put seller immediately gets the premium obtained from the sale of the put placed into her brokerage account which can be used to subsidize gas purchases. In exchange for the cash, the investor is taking on the risk that the stock might drop at or below the strike price at which time she will be forced to purchase the stock. In order to do this, you must be cleared for this level of options activity (ask your broker) and have the necessary funds available should you be forced to buy the stock. You should also be happy to own the stock at the strike price. (For more information on the mechanics of this strategy, see Recipe #6: Put Pot Pie.)

The Exxon exxample
Would I pick Exxon to pay for my gas? Let's consider the chart which shows that it's been channeling between $80 and $95 for the past year. Currently, it's trading right in the middle of its channel around $88, so if I were playing it, I'd wait until it traded below $82 before selling puts. Remember, the lower the price of the stock, the higher the premium you'll collect.

Now which strikes to sell? The weekly chart of XOM shows support levels at $5 increments from $80 down to its major support level at $55. (This means that the support levels are roughly near $80, $75, $70, $65, $60, and $55.) The strike price you select should be based on your tolerance for risk and where you perceive the price of oil will be in the future. Keep in mind, too, that the further away the expiration date, the riskier the play, so if you want to write an option for a year out or more, go for strikes that are further out-of-the-money.

Two ways to play it
You can sell puts on a monthly basis at strike prices that are closer to the current price, or sell longer term options that are further out of the money. Which method you choose is based on the amount of time you have to devote to selecting and watching monthly options as well as on the options premiums themselves. In the case of Exxon, the July 70 Put is selling for $0.10, the Oct 70 Put for $0.80, the 09Jan 70 Put for $1.80, and the 10Jan 70 Put for $5.00.

If I were to play Exxon, I'd probably choose the latter, long-term method. I'd wait until the stock dropped below $82 and sell any of the January 2010 leaps in the $55-$70 strike range. Then, since Exxon has a tendency to channel, I'd buy back the option when the price hits the $95 level and shows signs of rolling over. This pattern can be done every few months while collecting at least a few bucks per contract. For example, if you had sold the 10Jan 70 Put on January 22, you would have collected about $10/contract thus adding $1000/contract into your account. On April 24, the stock almost touched $95, and if you had sold your option then when it was trading for $4, you could have pocketed $600/contract. For all of you traveling salespeople in gas-guzzling vehicles, you'd probably need to sell more than one contract to cover your fuel bill.

I'm not sure that I'd be in Exxon for the very long term since its chart, along with many others in the oil sector, are looking a little tired. And having a long-term long position on it to me seems risky (selling puts is a bullish play), but if you elect to go this route, I'd set an alert for any major move below $80 and probably either roll-down the position or exit it altogether.

Well, there you have it--one way to stick it to “the man.” A much better way than siphoning gas--plus, it's legal. Tomorrow, I'm going to look at other companies in the oil sector to see if there aren't better (as well as cheaper) candidates for this strategy, so keep your motors running!

PS: Speaking of siphoning gas, if you're planning on renting a car on your summer vacation, insist on one with a locking gas cap.

*If you're unfamiliar with options, please refer to my links and as always, don't trade any strategy until you thoroughly understand it by paper-trading it first.

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