This year started with a bang for the stock of Cisco Systems, Inc. (NASDAQ:CSCO). But the party ended in a 10% correction from the May earnings report. The good news is that it eventually found its footing and is now back at levels of contention.
Usually, on big dips that come on heavy volumes solidify the valuation in prices. In this case, my thesis is that the tests that CSCO endured in May solidified its band of support for the rest of the year.
Today I want to bet that it holds and, if not, I will buy the shares. I will use the options to implement my trade.
From a valuation perspective, Cisco stock is cheap with a 17 price-to-earnings ratio, 3.6% yield and healthy net margins. CSCO price-to-book is barely over two so it won’t be a colossal mistake if I had to own shares at some point this year.
The analyst average price target for CSCO stock is $35.8 per share and most rate the stock as a “buy” with only a few on “hold.” So, in theory, the upside in this stock should be a guarantee. Still, I prefer selling downside as opposed to buying and hoping for rallies to materialize.
Technically, the picture for CSCO is also constructive but still too precarious. The spike that happened in February was completely and emphatically priced out. Although the bulls were able to find footing above $30, they are still fighting for the right to use $32 per share as support for further upside.
The band of prices around $32 is now pivotal. Meaning that bulls and bears battled over it for a year and the bears have prevailed twice and the bulls only once. If I buy CSCO stock outright now, I would be hoping that the bulls even the score. That is not my style.
I started my write up saying that big dips often create solid floors. So I have faith in the actual support that just recently held up. So I can confidently sell downside risk against those levels to create income out of thin air.
It would take a major management debacle for CSCO to falter on its own to breach this year’s lows. This is highly unlikely from this seasoned of a team. After all, CSCO is a survivor of the dot-com bubble.
I enter this trade with profits in hand from similar trades this year including when I caught the CSCO falling knife this May. But I still need the equity macro environment to hold steady. Meaning, like any other bullish equity trade, today’s setup is at the mercy of headlines from politicians into what is sure to be a fiery debt ceiling debate in December.
I am sharing the monthly chart to show the longer-term perspective of my support levels. I expect the area around $30 per share to hold as strong support as it’s been pivotal for a decade. This gives me the confidence to commit to owning it there and get paid for it.
The Trade: Sell the Jan 2018 CSCO stock $30 naked put and collect 85 cents to open. This is slightly more aggressive than my usual starting point at only 75% theoretical chance of success, but I do have profits in hand. If the price falls below $30 then I must own the shares and could accrue losses below $29.15.
For those who prefer finite risk rather than selling naked puts, they can sell credit spreads instead. There the maximum loss is limited by the width of the spread.
The Alternate Bet: Sell the Jan 2018 CSCO stock $30/$28 bull put spread. This spread has about the same chance of winning and it would deliver a 20% yield.
There are no guarantees when investing in the stock market, so I never risk more than I can afford to lose.
Learn how to generate income from options here. Nicolas Chahine is the managing director of SellSpreads.com. As of this writing, he did not hold a position in any of the aforementioned securities. You can follow him as @racernic on twitter and stocktwits.
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