By Mark Bern, CPA CFA
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 United Technologies (UTX) that the stock price was $71.85 (all prices and premiums quoted as of the market close on September 28, 2011) while the premium on the October $67.50 strike Put was $1.68. We collected $168 ($1.68 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 $159 net of commissions which represents a return of 2.2% for 23 days. If you annualized (using the method that I explained in detail in my first article) the return you would come up with is about 22% without owning any stock. Not bad if we can maintain this level of return. I really don’t care if I own stock or not if I can get a return like this consistently, but I don’t think that we are likely to fair this well regularly over the long-term.
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. I will be providing better examples in the near future on how and when to sell calls with a set of rules that I apply. For those who may be interested in the call side I have begun another series entitled “The Daily Call Sheet” (the initial article in that series can be found at this link) with suggested call premiums that meet my criteria on all the stocks within this series as well as many other widely held stocks.
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, for the remainder of this article I will focus on two topics: 1) next steps with UTX and 2) explaining some variations on the strategy. In future article in this series I will continue to address other related issues and more variations. I will also address other questions that were raised in comments to previous articles in these and future update articles in the series. I hope you will stick around until I’ve had a chance to fully expand the possibilities, the risks and other considerations that apply to enhanced income investing.
For those who read the earlier article on UTX, you will recall that I believe the company to be a well-managed, dominant company with exceptional upside potential. I may not have said it in those exact words, but there you go. I like UTX a lot and think that it is a great investment for the long-term. At its current price of $77.80, 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 seems to be verge of a correction. Actually, the market seems to be range bound. It will break out in one direction or the other eventually, but for the time being we could see the continuation of the range until a resolution of some sort is found for the European debt situation. Being near the top of the range, this is not the ideal time to sell puts unless you really want to own the stock and expect the economy to continue growing from here. My favorite put option on UTX at the moment is the February $70 strike with a premium of $2.71. After the commission you are left with a return of 3.37 percent, or 13.5 percent on an annualized basis. The exercise date is February 17, 2012, so you earn the 3.59 percent in just over three 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 $67.29 ($70 - $2.71). 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 even further, you could wait for UTX 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 while reducing your perceived risk. 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 significantly. 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 May 2012 put with a strike of $65 selling at a premium of $3.10. That would lock in a 7.1 percent annualized return over the next 6 months. If the option were to be exercised, your cost basis would be $61.90 ($65.00 - $3.10). For my hypothetical portfolio I will be using the shorter term (February 2012) puts and I will be selling on contract to collect a total of $262 in premiums ($271 - $9 commission). This will provide a balance for diversification purposes should I end up with the stock.
Before I go on to the next section I would like to explain in a little better detail why I chose the $70 strike price and a couple of other bits of information about UTX that the reader may find useful. Since about mid-August, the stock has been trading in a range of about $67 to $80. Selling a put at $70 gives us the potential of owning the stock right at the bottom of this range. That’s much better than owning it at the top of the range. If we miss it this time, I suspect we will have ample opportunity to try again. One of the reasons that the premium provides such a high return is simply because the market seems to be telling us that there is a relatively high probability of the price returning to that level or below. Buyers of the puts expect to make a profit by selling before expiration. This is a good place to remind the readers once again that about 83 percent of all options expire worthless. So, let me rewrite the above sentence to make sure you understand what was meant. The market seems to be telling us that there is a perception that the probability of the price returning to the strike price or below is higher than it would normally be. In other words, the odds are better than usual but still not much above 50 percent.
If you own or are considering a purchase of UTX in the near future there are some things you should know. First, the company has offered to purchase Goodrich Corporation for about $18.4 billion in cash, including the assumption of $1.9 billion in debt. This transaction, if accepted and approved by shareholders and regulators, will probably be slightly dilutive to shares in during the first year of integration. However, I believe that the deal will become accretive to earnings in year two because of synergies in the aerospace and defense sectors. The initial impact of this transaction along with the uncertainty in the global economy could affect the timeliness of a purchase of UTX. This is another reason I don’t feel good about buying unless I can get the company at or near the bottom of its current range. Long-term, I still believe in the potential appreciation of the company and like the dividend of $1.92. If purchased through the use of the put I proposed earlier, our yield would be 2.85%.
The company does a sizeable amount of business in the BRIC countries (Brazil, Russia, India and China), so if the global economy does not fall into recession earnings should continue to grow faster than companies with more exposure to developed economies. The most recently reported third quarter results were very good with the company beating slightly street estimates and guiding higher through 2011 and into 2012.
So, now let’s discuss some 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.
Several readers have asked questions on the subject of how to adjust the put-selling strategy once the overall market has begun breaking down and it appears that it will be trending down further. First, let me put this into perspective. Generally, the market corrects at least five to ten percent one or more times in nearly every rolling 12-month period. These are called dips or corrections, depending upon the severity of the move. The market cannot go straight up forever, so these periods of consolidation are actually healthy and allow the upward trend to continue. If the market goes up too far too fast, it will require more than a correction and go into a bear market trend. A correction is any down move of more ten percent or more but less than 20 percent. A 20 percent or more downward move in the market, without rallying back above previous highs, is considered a bear market. Bear markets happen, on average, about once in every four years. Sometimes bear markets do not occur for more than four years; sometime they occur more frequently. But, on average, you can expect a bear market about once every four years over the long term (here I define long-term as of a period more than 20 years in duration). In 2008, we experienced a bear market that lasted into March of 2009. But since the S&P 500 ended 2009 higher than it was on January 1st, it was not considered a down year. But 2008 definitely was down. So the averages are started to work against us since we have had three years in a row (2009, 2010 and 2011 hopefully) that have ended with the market higher than where it started. Usually presidential election years are good years for equities. That was not the case in 2008 and with the weakness in economies of the developed world, the potential for a down year in 2012 is a distinct possibility. I’m not making a prediction but, rather, I just wanted to point out that the risk of a bear market rises with each consecutive year of record highs. But then, the markets rebound and economies purge themselves of excessive debt and the cycle begins anew as we once again move to higher highs. That is the way of the equities market. Picking strong companies that can weather the storms and grow market share, even as weaker competitors fall, is the recipe to long-term investing success.
So, what do we do when the market begins to fall and breaks strong support levels indicating that more downward movement is likely to come? There are several ways to handle this situation. Each investor needs to understand the alternatives and select the one that best fits the objectives of his or her investing goals. In the case of an investor who prefers to hold on for the long term, selling calls with short durations is one option. The risk in this case is that the investor may continue to sell calls after the market bottoms and subsequently has the stock called away. To try to avoid this, I suggest that the investor either hold off on selling calls, increase the strike price while shortening the option duration or, if they have calls outstanding that are likely to be exercised, buy back those outstanding calls (even at a loss if necessary) once major support has been broken. Alternatively, if the investor did not react in time and has their stock called away, they can begin selling puts to repurchase the stock during the next correction. This may result in missing a portion of the upward move off the bottom, but it does get the investor back into their stock somewhere in the earlier stages of the rally. The investor can also decide to merely buy the stock on the first major dip of more than five percent. But short duration puts will do the same and provide the investor with some income along the way to offset the missed opportunity.
There is also the possibility of having the stock called away during a bear market rally which can move rather swiftly, retracing a significant portion of the downward move. In this case, the simple answer is to sell puts at or below where the stock was called away to get the stock back at no loss or possibly at a lower cost basis. This is likely to be affected by the “wash rules” of IRS which means that the initial loss, if any, cannot be included in a tax return. (For more information on wash rules go to irs.com and search within the “individual” area for the term “wash rule.”)
Another method of protecting an individual position in a dropping market is to buy a put option as protection against a loss on a stock being held through. I don’t necessarily promote this method because buying a put option is generally considered the riskiest position because it theoretically carries unlimited loss potential. But when the stock for the underlying stock is also held by the investor, the loss on the put is offset by the gain on the stock. The idea behind this method is that the reverse is also true. When the stock price drops the value of the option rises while the price of the stock decreases, offsetting most of the loss from holding the stock. This method uses considerable leverage (as much as 10-20 times) so the cost for hedging a position is relatively small. The biggest potential cost is the cost of the lost opportunity if the investor guesses incorrectly.
If an investor holds a well-diversified equity portfolio, they can hedge their entire position with an inverse ETF. If the investors is convinced that the market is going to fall there are also leveraged ETFs that will gain two or three times as fast as the related index drops. The idea is that a smaller investment is necessary to protect a portfolio than an outright short position. There are problems with using this strategy for more than a few days. The leveraged ETFs are a rare breed that reset daily which means that in a volatile market with large swings in both directions the protection will not be as great as expected. I don’t want to promote this method for this reason. If readers desire further explanation of how leveraged ETFs work, please mention it in the comments section and I will address it there.
There is another way to protect a position against significant loss. I did not include this method in the above section because it does not fit the traditional buy and hold strategy. But I thought it would be appropriate to include it here, just the same. Many investors use stop loss orders, usually set above their entry price, or at a pre-determined maximum loss level below their entry price. As the market moves up, the investor moves the stop loss order up to either protect more of their gain or to reduce the amount of loss they are willing to accept. This is normally a method used by short-term traders.
Finally, if a stock price is not acting as expected an investor should always have an exit strategy. Things change. If the fundamentals that led the investor to believe in the potential of the company have been altered, either by internal management moves or by external factors, the investor should have a price at which they intend to sell the stock in order to limit their losses. If the fundamental reasons that led the investor to purchase the company have not changed, but rather the overall market is correcting that, in my opinion, is not a reason to sell the stock. But that is my opinion and every investor needs to have their own plans for protecting their assets.
There are probably many other methods or variations on these methods that others employ. If readers have other alternatives that they use I welcome all to share explanations of those methods in the comment section. That is one of the great aspects of Seeking Alpha; it is a place where we can share our experiences and strategies in a way that we all can learn and gain from each other.
If you are a new reader and are confused about what strategy I keep referring to, please see the first article in the series for a primer.