By Mark Bern, CPA CFA
Many of my followers on this series are probably wondering why I haven’t published updates recently on many of the stocks for which the original puts have expired. I will admit that I have been waiting for a chance to assess the chances for a year-end rally. I’d hate to catch the top of a rally to sell some puts. Doing so would not give us the discounted price we seek.
At this time I do not foresee the Santa Claus rally running up much; thus I believe that a short-term top is in place and as prices drop we can begin to sell puts again. We shouldn’t wait for the bottom, though, or we won’t get the stocks at all. My intent is to let the correction we are now if play out a bit before I commit to new put positions. In some cases, events will give us opportunities on individual stocks earlier than on others. This happens to be one of those cases.
Best Buy (BBY) which recently took a hit of roughly 18 percent on bad news gives us the opportunity we need to sell puts on a quality company with excellent long-term potential at a bargain price. If the retail season this year doesn’t go as well as forecast, all the retailers will go down further, including Best Buy and I want a chance to get this gem at a real bargain.
First, let’s look back at what happened with the first put we sold on October 5, 2011. The price of the stock on that date was $23.16 and we sold one November $22 strike put for a premium of $1.04. We collected $104 and paid a $9 commission leaving us with net proceeds of $95. The contract expired worthless on November 18 and we got to keep the $95 giving us a return of 4.1 percent in just 45 days. Using the method explained in the original article explaining the strategy in detail, we get an annualized return of 20.5 percent. I wish we could just keep doing that over and over. And we did this with cash and not by owning stock.
So, what is a reasonable target price to shoot for on BBY now? Honestly, I expect the holiday season to be disappointing. I’ve been watching people in the checkout lines and the baskets have consistently had less in them than during any previous year at this time. My area has not been hit nearly as hard by unemployment as much of the nation, so I can only assume it is just as bad on average elsewhere.
I’d like to lock in a good premium here, and if there is panic selling we get the stock; if not we take the profits and roll the position to a more reasonable strike. I have two months I am considering: June 2012 and January 2013. The June put would give us a premium of $1.20 for a return of 4.8 percent after commission or 9.6 percent annualized. The January put has a premium of $2.39 for an immediate return of 9.9 percent and an annualized return of 9.1 percent. Both have a strike price of $20.
If we are put the stock, the June option would put us in the stock at a discount of 19 percent below the current price while the January contract would result in a discount of 24 percent. Either one is enticing, but since I really don’t think either will be exercised and, thus, I expect we’ll roll the position in a few months, I want to take the larger premium because we stand to end up with a better total return.
I also want to increase the number of contracts this time to two instead of one, for proper diversification and allocation purposes. Increasing the number of contracts will also improve our yield because we still have only one $9 commission to pay on the transaction. Let me make this straight: we are purchasing two January 2013 put options with a premium of $2.39 each.
That will result in our receiving $478 from initiating the transaction less the $9 commission giving us a net cash receipt of $469 or 11.7 percent on the cash we will need to hold in our account to secure the puts. That is better than the 9.9 percent return we would expect had we sold just one contract. Big difference, huh? If we annualize that we get a return of 10.8 percent if we don’t get put the stock. If the option is exercised and we get put the stock we will have a cost basis of $17.61. That would put the dividend yield at 3.6 percent. I like either outcome.
For readers who just joined the series and find the concept interesting, I would suggest reading the initial article that kicked off the series along with the comments to the article which came from investors with varied levels of experience and offered excellent variations. The second step I would recommend would be to read the first three updates (for Intel (INTC), United Technologies (UTX), and Union Pacific (UNP) and summary articles which provide further explanations of variations on the original strategy as well as the first set of portfolio results thus far.
My wish for each of my readers is a successful investment year in 2012 and beyond!