With options premiums on the high side these days, selling options on stocks like Valeant Pharamaceuticals (VRX) can be very lucrative if done intelligently. After all, the stock market has been volatile for months, and volatility makes options more expensive.
Now, let me start by saying that buying puts isn't suitable for small investors who lack access to liquidity. Still, investors might consider selling put options, even though that approach requires a lot of flexibility within your portfolio.
My absolute rule: Under no circumstance should you sell put options unless you're 100% comfortable with owning the stock in question and you have enough liquidity to absorb an option's short-term price swings prior to expiration. If an option's price goes against you and you don't have sufficient cash on hand, your broker will force you to sell securities or pony up more money.
That being said, let's look at buying an option on beleaguered biotech Valeant, which has been in the news a lot and experienced plenty of volatility.
VRX is rallying to about $31 a share today, but Mr. Market is dealing with a lot of uncertainty about the company. However, I believe the odds are minimal that the company defaults on its bonds.
Further, VRX's revised 2016 earnings-per-share estimate of $10 (down from an earlier $13) could be off by 50%. And the company still trades for about 6x earnings as of today.
So, consider what would happen if you sell a May 2015 VRX $25 put, which is trading for nearly $5 per contract today.
You'll have to buy the stock if Valeant winds up selling for less than $25 on the put's expiration date. However, the put premium you receive will net your cost down to $20 a share.
Conversely, you'll simply keep the $5-per-share premium if VRX is trading above $25 when the put expires. That would represent a nearly 18% gain from today's stock price over a two-month holding period, or better than a 100% annualized gain.
Of course, an investor has to be very confident that Valeant still holds some equity value (a factor that some are questioning today).