This Controversial Stock Could be the Ideal Income Generator

By Alan Knuckman,

Shutterstock photo

Hedge funds have been lining up on both sides of the fence regarding nutritional supplement multi-level marketing company Herbalife Ltd. ( HLF ) . Thestock made a52-week high of $73 last spring beforeshares took a huge hit following accusations fromhedge fund investor William Ackman that the company was nothing more than a pyramid scheme.

The seven-month trading range between $56 and $42 a share projected a downside target of $28 ($14 height of the pattern subtracted from the breakdown level of $42). A volatility spike occurred when the downside channel support at $42 was broken in December, and as often happens at price extremes, the selling pressured the stock to $24 before a rebound. 

Recent action has seen the price rally back above breakdown point at $42, which acts as the pivot point, to about $44. As the battle between short sellers and value buyers continues, traders can use a different approach toprofit from Herbalife.

Because of the high volatility (another word for opportunity), the options on the stockoffer many strategies with mathematical advantages over a straight purchase of the shares. In particular, sellingput options could allow us to collect income while we wait to get into the stock at an even bigger discount.

Cash-secured put selling strategy
While the typical investor might use alimit order to buy a stock orexchange-traded fund ( ETF ) at a designated price or lower, the options trader can do one better by selling a cash-secured put.

This strategy has the same mathematical risk profile as acovered call . With put selling, there is anobligation to buy the stock at thestrike price if it is assigned, allowing you to get into the stock at a discount. In fact, the true entrycost basis is even lower with the subtraction of the premium you earned from selling theputs .

And if the stock is not below the strike price atexpiration , then the premium received is all profit. In other words, you're getting paid not to own the stock.

There are two rules traders must follow to be successful at selling put options.

Rule One: Only sell puts onstocks you want to own.

The intention of this strategy is to be assigned the stock as a long-terminvestment (eachoption contract represents 100 shares). So make sure you have thefunds in your account to buy the stock at the options strike price if a sell-off continues. Paying in full ensures that no additionalmoney is needed to hold the stock for potentially many months or even years until a price recovery.

Rule Two: Sell either of the front two option expiration months to take advantage of time decay.

Collect premium every month on put sales until you are assigned shares at a cost-reducedbasis . Every month you keep the premium is money subtracted from your entry price.

Action to Take --> Sell to open HLF Feb 30 Puts at $1 or better.

This cash-secured put sale would assign long shares at $29 ($30 strike minus $1 premium), which is about 34% lower than Herbalife's current price, and would cost you $2,900 per option sold. Remember: Only sell this put if you want to own Herbalife shares at a discount to the current price. If you are assigned the shares, a March covered call can be sold against the stock to lower your cost basis even further.

And if the stock does not fall below the strike price before expiration, then you keep the premium you collected, essentially getting paid not to buy the stock.

This article originally appeared on
This Controversial Stock Could be the Ideal Income Generator

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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This article appears in: Investing Stocks
Referenced Stocks: ETF , HLF

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