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While the market has been stumbling along the past few months a few sectors have experienced considerable gains. The most notable is agriculture, as seen through the PowerShares Agriculture ETF (NYSE:DBA).
The agriculture ETF has advanced roughly 19% since the year began and doesn’t seem to be slowing down.
Why has the rally been so fierce in agriculture? It’s simple supply and demand economics. Shortages in coffee, cocoa and sugar have sparked the fierce rally in DBA. The three commodities combined make up 35% of the agriculture ETF.
But if you look at the intermediate-term indicator, Relative Strength Index or RSI, you can quickly see that the current move should start to fade a bit. The RSI measures how overbought or oversold a stock or ETF is for a certain period of time. In our case, we are using an intermediate-term timeframe. A reading above 80 means the asset is overbought. A reading below 20 means the asset is oversold.
And right now, agriculture commodities are severely overbought.
So, here’s how I’m playing it.
I really like the agricultural commodities ETF over the long term, but I think it might be a bit rich at $28.68.
I’m willing to pay $27, or roughly 6% off the current price of $28.68. And I’m willing to do so for an 8.7% return on my capital. Huh?
That’s right…while I’m waiting for DBA to come back to my price, I am going to collect 8.7%.
Most investors would just set a limit price for $27 and move on. But we seriously need to consider the opportunity cost of setting a limit price. Remember, the cash needed to buy DBA must be in your account to purchase shares of the agriculture ETF. Unfortunately, the cash is collecting next to nothing while you wait.
By selling $27 puts on DBA, I can collect $50, while only having a cash requirement of $580 or roughly 20% of the total cost of 100 shares of the ETF.
I know this can be a bit confusing for some of you, but stay with me, because this is a very important concept that you need to consider before each and every stock or ETF you purchase.
Selling puts is a very simple concept that is largely ignored by investors. Hopefully after the following example, I will have a few of you interested in how to use this simple strategy in your own portfolio. Let’s take a look.
DBA is currently trading for $28.68
Given our desire to own DBA at $27, we will simply sell one DBA put for $50. Think about that: We can collect money, thereby lowering our cost basis, just by agreeing to buy DBA at a lower price.
Again, we can sell one put contract that gives us the ability to buy 100 shares of DBA at $27 a share – and collect an immediate $50.
And no matter what happens, we get to keep that $50. If DBA stays above $27 through chosen time frame, otherwise known as the options expiration cycle – the $50 we collected is ours. More importantly, we continue to sell puts on DBA until our stated price is hit, collecting more and more income every few months.
But for the sake of understanding, we should examine the alternative – DBA closing below $27 at option expiration.
In that case, we’d keep the $50 and be forced to buy DBA stock at $27 per share.
In our case, we’d actually own the stock for $26.50 per share – that’s the $27 strike price minus the $0.50 premium. That is 7.6% less than DBA’s current market price of $28.68.
Here’s that math:
Initial income from sold put premium – $50
Purchase 100 shares of DBA at $27 – $2,700
Initial outlay – $2,650
The important thing to remember is that if the agriculture ETF trades below $27 by option expiration, you become a shareholder just like everyone else … but at a discount.
Selling puts is not inherently dangerous. If used correctly, it’s no more dangerous than any other type of investment. In fact, it’s often safer.
I really like DBA’s prospects over the long term. I just don’t want to own the ETF at its current price. It’s just too rich at the moment. I am willing to buy it at $27. And I’m more than willing to sell a put and collect a return while I wait for the ETF to hit my stated price.
To reiterate – you get paid to make a promise to buy a stock you want to own, AT the price you want to pay.
I have to urge caution – and point out the obvious: You would never sell puts on a stock that you didn’t want to own at that strike price. That’s how most people get in trouble – they only pay attention to the income – forgetting that they CAN and eventually will get put to the shares.
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