Although options can be extremely risky, selling put options can be a fairly conservative way to generate income or to buy stocks at a pre-determined price. It’s advisable to only do this for stocks that you’d be happy owning at the strike price – otherwise you could end up with a cost basis far above the intrinsic value of the stock. Here are three stocks that I’ve written about recently which are undervalued and have attractive put options.
NVIDIA Corporation (NASDAQ:NVDA) – I wrote recently that NVIDIA Corporation (NASDAQ:NVDA) is deeply undervalued, with a large amount of cash and a robust free cash flow, and valued the stock between $16 and $20 per share. If fact, even under a no growth scenario the stock would be worth about $13 per share, higher than the current share price. NVIDIA Corporation (NASDAQ:NVDA) has about $3.73 billion in cash on the books, roughly $6 per share, meaning that cash represents almost half of its total market capitalization. With just over $1 of annual FCF/share, that puts the P/FCF ratio after subtracting out cash at 6.1. This seems outrageous given NVIDIA Corporation (NASDAQ:NVDA)’s dominant market position in graphics processors.
Now, your goal determines what strike price at which you should sell a put option.
If you want to buy the stock, then you can sell an at-the-money put option. The $13 strike price is slightly above the current stock price, meaning that if the stock stays flat through expiration you would be put the shares at $13 per share. If the stock price rises above $13 then the option would expire as worthless. The April $13 put option comes with a premium of $56 per contract, which would make your effective purchase price $12.44 if the option is exercised. If the option expires worthless, the premium represents a 4.3% return in 38 days.
If you want to generate income then you can sell an out-of-the-money put option. This creates a buffer so that the stock price would need to fall before the option is exercised. The April $12 put option comes with a premium of $15 per contract. The stock would have to fall about by about 6% from the current market price as of this writing for the option to be in the money. If the stock remains flat, then the premium represents a 1.25% return in 38 days, or 12% annualized.
Another option is the June $11 put option. This offers a larger buffer of about 13% in exchange for a lower annualized return of 7.2% over 101 days based on a premium of $22 per contract.
Cisco Systems, Inc. (NASDAQ:CSCO) – Cisco Systems, Inc. (NASDAQ:CSCO) is in a similar situation as NVIDIA Corporation (NASDAQ:NVDA), with a lot of cash on the books and a strong cash flow. I put the realistic fair value of a share of Cisco Systems, Inc. (NASDAQ:CSCO) at a minimum of $25 per share, meaning the stock is currently undervalued by about 17%. Cisco Systems, Inc. (NASDAQ:CSCO) has a net cash position of $30 billion, or $5.60 per share, making up 26% of the total market capitalization. And with over $10 billion in FCF per year, the P/FCF ratio adjusted for cash is about 8.5. Cisco Systems, Inc. (NASDAQ:CSCO) absolutely dominates its core markets, with a wide moat and a renewed focus after years of sub-par acquisitions.
If you want to buy the stock then you can sell the April $22 put option. The strike is just slightly above the current market price, meaning that the option will be exercised if the stock price remains the same. A premium of $68 per contract knocks your effective purchase price down to $21.32 if the option is exercised. Otherwise the premium represents a 3.09% return over 38 days.
If you want to generate income then you can sell the April $21 put option. The buffer against exercise is about 3.2%, and the premium of $24 per contract represents a 1.1% return over 38 days, or 11% annualized.
If you want a bigger buffer against a stock decline you could sell the June $20 put option. The buffer here is 7.8%, and the premium of $39 per contract represents a 1.95% return over 109 days, or 7% annualized.