By Mark Bern, CPA CFA
Those who read my first article on Walgreen (NYSE:WAG) may recall the reasons why I like the company as detailed in that precious article. Also, many of my followers on this series may be wondering why I haven’t published as many 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, the rally looks to have run its course, thus, I believe that the short-term top may be 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 that I expect play out a bit before I commit to many new put positions.
Walgreen is an exception, because of the Express Scripts situation. I think that most, if not all, of the downside expected is already built into the stock price at this point, and that we may now be facing an opportunity to sell puts that could get us into this stock at a really good cost basis.
Our first attempt to buy WAG stock failed, but we got paid to place the order, so to speak, because we sold a November put option contract with a strike price of $31 for a premium of $1.19, and we got to keep the premium, less the commission, for a net profit of $110. That works out to a return of 3.66 percent on our cash held in the account as security for a period of less than two months. I use a different sort of annualizing method that can be found in the original article that started this whole series. If you get confused about the strategy, I highly recommend going back to that first article for a detailed explanation. Using the methodology, we get an annualized return of almost 17 percent on cash without even buying the stock. Back on September 29, 2011, when we initialized the original position, the price of the stock was $32.53. Now it is time to make another attempt at buying the stock using the same strategy. Let’s see how much more we can skim from the option buyers this time.
The current price of WAG is $33.36 and the current dividend yield is 2.7 percent. Our objective is to improve on both of those numbers; lower the cost and increase the yield. To achieve that objective, we sell a put option contract. My favorite put option available today (as of the close on December 27, 2011) is the February $33 strike put that will pay us a premium of $1.52 per share. So, by selling this put, we must commit to hold $3,300 in cash in our account to secure the put until it expires on February 17, 2012. That is less than two months away, and our return over that period will be 4.33 percent, after paying a commission of $9. To explain, we receive $152 for selling the put, less the commission, which nets us $143. So, if we divide $143 by $3,300 to get the 4.33 percent return. Now we multiply that return by five (see detailed explanation in the original article linked in the paragraph above) and see that we get an annualized return of 21.67 percent. That’s even better than the first time.
Now, if the stock drops below the $33 strike price and remains there past the expiration date in February, we will get put the stock. In other words, we will be obligated to buy the stock at $33. But, we have already received $1.52 per share, so our cost basis will actually be only $31.48. And the dividend yield on that price will be almost 2.9 percent.
I hope you are beginning to see the power of this strategy over pure buy and hold. If you are confused or don’t quite understand the mechanics, please refer to the details provided in the first article of the series,
The object is to achieve an average of 10 to 12 percent return on cash until we purchase the stock, and then to receive cash from dividends and selling calls of at least eight percent on our overall portfolio holdings. In the end, we want to achieve annual income from the portfolio of about ten percent while not giving up the appreciation potential. It’s a delicate balance, but once you have the system down, it becomes very rewarding. The final objective of the strategy is to remove as much emotion from the investing decisions we make to keep us from buying high and selling low as so many of the investing herd seems to do.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I intend to sell the puts on WAG as described in the article.