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Selling puts is a good strategy to employ when you are bullish on the long-term prospects of the stock and most importantly the stock has experienced a strong correction. While there is no guarantee that a strong correction ensues that a bottom is in place, it does usually provide one with a good long-term entry point. This is especially true if the long-term outlook for that company is bullish. The sale of puts also provides you with some downside protection. Your breakeven point is lowered by the premium you received when you sold the put. For instance, if you sold the Jan 2013, 80 put on Philip Morris (NYSE:PM) for $1.70, your break-even point would drop from $80 to $78.30.

Today we are going to look at the Altria Group (NYSE:MO) as the long-term outlook is still bullish and the stock has pulled back rather strongly over a short period of time. Instead of just selling puts, we are going to modify the strategy slightly. We will sell a put and use some of the proceeds to purchase a call. The put provides you with the opportunity to get into the stock at a great price. The call provides you with the opportunity to lock in gains while you are waiting for the stock to be put to your account. We will examine the stock both from a technical and fundamental perspective. However, before we go any further, we would like to list some of the benefits associated with selling puts.

Benefits associated with selling puts

  1. In essence, you get paid for entering a "limit order" for a stock or stocks you would not mind owning.
  2. It allows one to generate income in a neutral or rising market.
  3. When you sell a naked put you are in a way acting like an insurance agent. The Seller of the option agrees to buy the stock in the future if it drops to a certain level before the option expires. For this, you (the seller) are paid a premium upfront. If this strategy is repeated over and over again these premiums can really help boost your returns over time.
  4. Acquiring stocks via short puts is a widely used strategy by many retail traders and is considered to be one of the most conservative option strategies. This strategy is very similar to the covered call strategy.
  5. The safest option is to make sure the put is "cash secured." This simply means that you have enough cash in the account to purchase that specific stock if it trades below the strike price. Your final price would be a tad bit lower when you add the premium you were paid up front into the equation. For example, if you sold a put on a stock with a strike at 20 for $2.50, and the shares were put to your account. Your final price per share would be $17.50 after the premium was factored in.
  6. Every day, you profit via time decay as long as the stock price does not drop significantly. Time decay is the greatest in the front month.

The majority of traders opt to close the put out prior to expiration if they have the chance of buying it back at a much lower price. For example, selling the put at $2.50 and buying it back at $0.50.

Points of interest

  • A healthy yield of 5.7%
  • A strong positive levered free cash flow of $.49 billion
  • It is a true dividend champion having consecutively raised its dividend for over 46 years.
  • A quarterly earnings growth rate of 3.8%
  • A total 3 year rate of return of 83%
  • A five year dividend average of 8.00%
  • A healthy interest coverage ratio of 5.5
  • The company increased the dividend by 7.3% and purchased over $260 million in stock in the 3rd quarter.
  • Management expanded the current share repurchase program by $1 billion to $1.5 billion.
  • EPS grew by 3.6% in the 3rd quarter and by 7.8% for the first nine months of the year.
  • Zacks has an estimated 3-5 year EPS growth rate of 6.4%
  • The top-selling Marlboro brand increased its market share in the quarter by one percent to 42.7%.

Charts of Interest

(click to enlarge)

In general, stocks tend to perform better when they are trading above this line. Altria Group is trading nicely above the consensus EPS line, which suggests that the current correction could be a good place to establish new positions.

How does Altria Group hold up to the competition?

We are going to compare it to its peers using several key metrics such as P/E, quarterly revenue growth, operating margins, PEG, etc. With this data investors can get a better view of the company and its competition. If you find one of its competitors to be a better play, you could implement a similar strategy. It has one of the highest operating margins in the industry, and its P/E is below the industry average of 16.88.

MO

PM

(NYSE:LO)

(NYSE:RAI)

Industry

Quarterly revenue growth

0.03

-0.05

0.05

-0.04

0.06

Revenue

17.39B

31.6B

4.55B

8.31B

8.31B

Gross Margin

0.55

0.67

0.52

0.48

0.52

EBITDA

7.61B

14.58B

2.07B

2.93B

2.93B

Operating Margin

0.42

0.44

0.45

0.34

0.38

Net Income

3.90B

8.54B

1.10B

1.44B

N/A

EPS

1.92

5.00

8.35

2.50

2.50

P/E

15.80

16.58

13.48

15.94

16.88

PEG (5 yr expected):

2.11

1.60

1.54

2.02

1.60

P/S

3.58

4.42

3.21

2.70

3.63

M= Million B= Billion

Technical Outlook

The stock has pulled back rather strongly over a short period of time. From its high in August to its current low, it has shed over 20%. Historically such strong corrections have proven to be long-term buying opportunities. It has a very strong layer of support in the $28.00-$29.00 ranges. If this level is taken out an even stronger layer of support comes into play in the $24.00-$25.00 ranges. You could divide your money into two lots and put the suggested strategy to use as each level is hit. Consider waiting for it test $29.00 before putting this strategy into play.

A weekly close below $24.00 will be a bearish development and signal that the stock is ready to put in a series of new 104 week (2 year) lows. If it closes below $24.00, you should either close the position out or roll the put. To do this you would simply buy back the put and sell new out of the money puts. On the other hand a weekly close above $32.50 will be a bullish development and signal that the stock is ready to trend higher and potentially test the $35.00-$36.00 ranges.

The strategy

Part 1

(click to enlarge)

The June 2013, 29 puts are trading in the $1.63-$1.66 ranges. If the stock pulls back to the stated ranges ($28.00-$29.00), these puts should trade in the $2.15-$2.30 ranges. We will assume that these puts can be sold at $2.15 or better. For each option sold, $215 will be deposited into your account.

Part 2

(click to enlarge)

The June 2013, 33 calls are trading in the $0.37-$0.41 ranges. If the stock pulls back to the stated ranges, these options should trade in the $0.23-$0.27 ranges. We will assume that the calls can be purchased at $0.27 or better. We are only going to purchase 2 calls for every put sold. If the stock is put to your account, then you will still be able to apply some of the premium to lower your overall cost. In this case, your cost per share will be $27.39.

Transaction details

  1. After selling the put and purchasing the call, you will be left with a net credit of $161 ( $2.15 premium from the sale of the put is subtracted from the cost of purchasing two calls, which in this case is $0.54)
  2. Your total risk is $2739.
  3. Your breakeven point is $27.39.
  4. Your profit potential is unlimited as a result of the call your purchased.

(click to enlarge)

Benefits and risks associated with this strategy

  1. The opportunity to leverage your position without any out of pocket expense as part of the put premium is being used to purchase the calls.
  2. The chance to get into the stock at a price of your choosing. If the stock trades below the strike price you sold the puts at, the shares could be assigned to your account (assignment usually occurs on the last trading day of the option). In this instance your final price will be $27.39, which is significantly lower than the current price of $30.34. The great part about this strategy is that you get to put in a limit order but your final price if the shares are assigned to your account is well below the limit price. If someone put in a limit order at $29.00, they would have to pay $29.00 per share if the stock traded down to this range.
  3. As long as you are bullish on the stock, having the shares assigned to your account should not be an issue. The only real risk is that you have a change of heart and are no longer bullish on the prospects of the stock. In this case, you can roll the put. Buy back the old puts and sell new out of the money puts.

Conclusion

This is a great way to attempt to establish a position in a company that has stellar history of raising its dividend, and that has rewarded its shareholders richly over the years. Consider waiting for the stock to pull back to the stated ranges before putting this strategy to play. The suggested strategy provides you with the opportunity to get into the stock at great price, but it also provides you with the chance to lock in gains if the stock should take off while you are waiting for the shares to put to your account.

Do not abuse this strategy as the shares could be put to your account, and you will need to have the money in place if this occurs. Generally speaking, the number of puts you sell should be based upon the number of shares you would not mind owning. If the shares are put to your account, you will have no problem paying for them. Consider taking some money off the table, when the calls are showing gains in the 60%-100% ranges..

Options tables sourced from yahoofinance.com. Option Profit loss graph sourced from poweropt.com. Competitor comparison data sourced from yahoofinance.com. EPS chart sourced from zacks.com.

Disclaimer

It is imperative that you do your due diligence and then determine if the above strategy meets with your risk tolerance levels. The Latin maxim caveat emptor applies-let the buyer beware.

Source: Get Into Altria Using This Low-Risk, High-Reward Strategy