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By Mark Bern, CPA, CFA

Well, we didn’t get put the stock on the first try, but we did collect the premium on the put we sold. Recall from my first article on Intel that the stock price was $21.94 (all prices and premiums quoted as of the market close on September 21, 2011) while the premium on the October $20 strike Put was $0.28. We collected $28 ($0.28 x 100) on the one contract that we sold, but we also paid a commission of $9 (assumed amount that is about the average of discount brokerage premiums; you can do better if you shop around). That leaves us will $19 net of commissions which represents a return of 0.87% for 37 days. If you annualized that return you would come up with about 8.8% without owning any stock. Not great, but not bad either.

For purposes of this series, I will not be breaking down the results of the calls. The example that was provided in the article was for illustration purposes only. If an owner of Intel had sold the call used in the previous article and did not buy the call back before expiration, they would have had their stock called.

The call that was listed had a strike price of $24 and a premium of $0.20, meaning that the owner would have received $24.11 ($24 + $0.20 per share minus commission of $9) per share for their stock. Intel now trades for $24.54 as of market close on October 31, 2011, and is down another 3 cents in after-hours trading. There is a good chance that one could reenter the stock at or below the price which they received within the next few trading sessions if that is what is desired.

The alternative would be to use the strategy of selling puts to reenter at a substantially lower price in the not-too-distant future and receive income from the put premiums while we wait. If an investor has their stock called away for $24.11 and is able to purchase the stock again at a cost basis of less than $22, would this be so bad? Even if the investor had held the stock since the summer of 2009, having bought near the bottom at, say, $14, they would be paying a capital gains tax of 15 percent on the gain, or $1.52 in taxes. In order to come out ahead, the investor needs to buy the stock back at less than $22.59, less commissions, to break even. Granted, the objective is to own the stocks long-term and collect the dividends plus call premiums so we will do our best to sell calls in the future that have less chance of being exercised.

We will include more information of call selection in this series in the future only after we have been put the stock. That will keep this series more focused upon the return to the complete strategy rather than mixing it up with other issues. We will build a portfolio of dividend-paying stocks over time and compare our return to the return of the broader market after two years.

Now I will focus on two topics: 1) next steps with Intel and 2) explaining some variations on the strategy. For those who read the earlier article on Intel, you will recall that I believe Intel to be a well-managed, dominant company with exceptional upside potential. I may not have use those exact words, but now I have. I like Intel a lot and think that it is a great investment for the long-term. At its current price of $24.54, I believe that the company still represents a good value.

However, with all the uncertainty in the market today, I think the volatility will give us an opportunity to buy this company at a better price. The stock is nearer the high end of its range in recent quarters, and the market just underwent a strong rally. This is an ideal time, in my opinion, to sell calls if you own the stock. My favorite put option on Intel at the moment is the February $23 strike with a premium of $0.97. After the commission, you are left with a return of 3.59 percent, or 10.76 percent on an annualized basis. The exercise date is February 17, 2012, so you earn the 3.59 percent in less than four months. Not a bad return on cash these days.

But I expect that we’ll get a chance to exercise this option by February 2012. If we do, we will have a cost basis of $22.03 ($23 - $0.97). Having said that, I would like to caution readers that there remains a possibility that we could see the markets swoon again due to stresses on the financial system caused by concerns over the sovereign debt crisis in Europe or a number of other non-company-specific factors. If you are concerned about such factors and believe that the market will drop back down to the lower end of its recent range, you could wait for Intel to drop some more, and sell a put at a lower strike. If you do, you could miss some of the income potential from the strategy. But that is a decision each investor needs to make for themselves.

There are also some longer-term puts available that pay higher premiums, but because of the longer time to expiration, the annualized return drops to around 8.2 percent. Then again, you would be locking in a good premium with a lower strike. If that suits your investment comfort level more, I would suggest that you consider the Jan 2013 put with a strike of $22.50 selling at a premium of $2.46. That would lock in an 8.28 percent annualized return over the next 14 months. If you were able to exercise the option, your cost basis would be $20.04 ($22.50 - $2.46). For my hypothetical portfolio I will be using the shorter term (February 2012) puts and I will be selling two contracts to collect a total of $185 in premiums ($97 + $97 - $9 commission). This will provide a better balance for diversification purposes, should I end up with the stock.

So, now let’s discuss the first variations to the strategy. First, let me reiterate that the two primary goals are to get paid on cash while we wait for a good price on a quality stock we want to own, and to increase the yield we receive in cash on stocks we own. In this article, let me focus on the first part of the strategy because that is essentially where we are today in terms of building this hypothetical portfolio.

I have expressed my preference to sell put options that expire in less than four months. I really have focused personally mostly on options which expire within three months or less. However, there are opportunities that may be missed if we don’t expand our horizons.

As some of my regular readers may recall, I have expressed dismay that I have not been able to provide an illustration for Procter & Gamble (NYSE:PG) using short-term options for selling calls. The premiums were too low and did not boost my return adequately. I have since looked at longer-term calls for PG and have found that the premiums can provide excellent returns. On the flip side, finding put options with good premiums on PG have been relatively easier to find.

However, I want to consider a variation on the strategy so let’s look at put options that are medium-term (six months) while thinking longer-term for selling calls. If we look at the put options that expire in April 2012, we will find that the $62.50 strike option has a premium of $2.73. If we sell this option and get put the stock, we will have a cost basis of $59.77. The premium of $2.73 provides an annualized return of approximately 8.45 percent ($2.73 - $9 / $62.50). I use the strike price to calculate the annual return because this represents the amount per share in cash we need to have in our account to sell a cash-secured put option. We are not selling naked options, ever. That is not part of the strategy. We sell put option in order to buy the stocks we want to own or, alternatively, to create a stream of income on cash in the event that we do not get put the stocks.

This isn’t a huge variation, but it does stray slightly from my original explanation that stresses short-term by reaching out a little longer to get a better yield.

Finally, I would like to discuss the best times to use puts and calls in terms of stock price fluctuations. When the stock is in the bottom half of its recent (six-month) trading range, especially when the stock has been falling in price for more than two out of the last five sessions, the premiums on put options will tend to be higher and an investor may have an opportunity to sell an option near the bottom of the recent range and still get a good return if the option is not exercised. The investor also has a better chance to get put the stock through exercise near the bottom of the price range for the stock which creates an excellent entry point.

On the reverse side, when looking for the best time to sell calls the investor can usually get better premiums after the stock has rallied to near the top of its recent price range. The premiums are usually higher then and the likelihood of losing the stock by having it called away through exercise is also much lower. We are not really trying to time the market. This is simply setting targets for entry and sticking to them.

For reference, the strategy to which I keep referring is detailed in the first article in this series.

Disclosure: I am long PG.

Source: Enhanced Income Strategy For Intel, Update 1