Merck is a solid defensive name that is showing relative strength and also pays a high dividend. Investors looking to purchase Merck stock can potentially do so at a discount by using an options strategy called a cash secured put.
A cash-secured put involves writing an at-the-money or out-of-the-money put option and simultaneously setting aside enough cash to buy the stock. The goal is to either have the put expire worthless and keep the premium, or to be assigned and acquire the stock below the current price.
The strategy is very similar to a covered call and is quite easy to understand once you know the basics.
It's important to know that those selling puts understand they may be assigned 100 shares at the strike price.
Merck Stock Strategy Gives Traders $300 In Premium
Using Merck stock as our example, a trader selling the July 21, 115-strike put could generate around $3 in premium per contract, or $300.
The put seller would have the obligation to purchase 100 shares of Merck stock at 115 if called upon to do so by the put buyer.
The break-even price for the trade can be calculated by taking the strike price less the premium received. In this case, that's a break-even price of 112.
That's 5.26% below Wednesday's closing price.
If the stock stays above 80 at expiry, the put expires worthless, leaving the trader with a healthy 2.68% return on capital at risk. That works out to around 12% on an annualized basis.
Risks Of Cash-Secured Puts
The main risk with the trade is similar to outright stock ownership. If the stock falls precipitously, the trade will suffer a loss, however the loss will be partially offset by the premium received for selling the put.
The maximum loss on the trade would occur if Merck stock fell to $0 which would see the trade lose $11,200, but most traders would cut their losses before then.
A stop loss could be set if Merck stock drops below the 50-day moving average, currently around 110.
Cash-secured puts are a fantastic way to generate a nice return on stocks the trader is happy to own.
If the put does get assigned, the investor takes ownership with a reduced cost base and can potentially begin selling covered calls to generate additional income from the position.
According to the IBD Stock Checkup, Merck stock is ranked No. 7 in its industry group and has a Composite Rating of 89, an EPS Rating of 57 and a Relative Strength Rating of 93.
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Please remember that options are risky, and investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ
