Learn How To "Protect" a stock, AND Simultaneously Generate Income

I love the versatility of options. 

Consider JAZZ Pharmaceuticals (JAZZ).  This stock has had an upward chart since its inception, currently trading at just under $155.00.  Some time ago, I sold a naked put on JAZZ at a $105 strike, expiry in 2016.  I collected a premium of $16.42, or $1,642.00 for each contract (recall that options trade in contracts, each contract controlling 100 shares, ergo, $16.42 x 100=$1,642.00).

Since that trade, the stock has rallied about $40 (or 40 points in the "lingo").  I'm beginning to wonder if it's going to pull back some, and I want to protect my profits from the sale of my put.

Recall that if you sell something, you take money in; while if you buy something, you pay money.  When you sell a put, you take premium money into your account; likewise, if you buy a put (or a call, for that matter), you pay money.  In this case, I sold a put, and received a premium of $1,642.00, as above.  That premium is now down to $868.00.  Since it is less than what I received into my account, it follows, then, that I would have less to pay in order to close this position.  In this case, to buy the put back to close, I would have to pay $868.00, but since I received $1,642.00, my profit would be $774.00, or 47.13% of my original premium.

But wait, there's more ...

As long as JAZZ remains so far above my sold strike price of $105, the likelihood of being "put" the underlying stock are relatively slim.  Therefore, I am inclined to keep my naked put and let it continue to "cook" until expiration.  This exposes me to some risk (that the stock will pull back dramatically, and I will be put the stock, in which case my basis would be $105-16.42=$88.58). 

So here's my dilemma, for lack of a better word: The stock is currently trading at about $155.  If I wish to "protect" that price of $155, I can do a couple of things: Buy a protective put at the $155 strike price, or sell a Bear Call Spread, or buy to close my naked put position.  Let's examine these possibilities (we've already discussed buying back the put to close the position).

If I buy a $150 strike put expiring in, say, January 2015, it would cost me $25.90, or $2,590.00 per contract (each contract controls 100 shares).  That's rather expensive.  But I can mitigate that cost! How? By selling monthly puts against it.

The next expiry is February 21, 2014.  The JAZZ $150 strike put currently sells for $4.30.  That means that my total outlay would be $2,160.00 ($2,590.00 - $430.00).  The caveat, of course, is that I have to be pretty comfortable that JAZZ would close above $150 by the February expiration, or it might be put to me at $150.  If it is put to me at $150, my basis would be $171.60 (because I paid $2,160.00 to own the protective put).  However, if the stock does decline and is put to me, I am not obligated to retain it - I exercise my $150 put.

If JAZZ remains above $150 by the February 2014 expiration, my premium of $430 will be mine to keep, and I can then sell the March expiration $150 put for more premium.  The idea here is to sell enough monthly premiums to pay off the cost of the protective put ($2,590.00), and hopefully make some income at the end of the line.

Let's look at a different scenario: With JAZZ currently selling at approximately $155 on the market, I could sell a January 2015 $150 put at $25.90 (for the sake of simplicity, I am not going to discuss bid and ask prices.  This is simply for illustration purposes).  Recall that when I sell something, in this case premium, I receive $25.90 or $2,590.00 into my account.  That's a very nice chunk of change, but also carries a risk, that the underlying stock pulls back below the strike of $150 and is thus put to me.  In that event, my cost basis in the stock would be $124.10.  I don't have to keep it - I could sell it back to the marketplace, or sell covered calls.

Let's see what happens if I sell an out-of-the-money $150 strike put expiring in January 2015.  I'm now on the line to be put a stock at $150.  I can mitigate that risk by buying the February 2014 $150 strike put at $430.  In this case, my premium credit would be reduced by the purchase of the put to $2,160.00, but I am also protecting myself against having the stock put to me.  I'm not as fond of this strategy.