By Mark Bern, CPA CFA
Johnson Controls (JCI) was elusive in our first attempt to purchase the stock through the use of our strategy. Those who read my first article on JCI (here) will recall that we picked up an $111 profit in just over a month without buying the stock. That amounted to an annualized return (calculated by a method explained in the initial article of the series which is linked in the next paragraph) of 23%. If that sort of return is of interest, please read on to understand how we achieved it and how I intend to achieve more of the same on JCI in the next few months.
Let me begin by pointing to a detailed explanation of the strategy that can be found in my original article that I used to initiate this series (here). As you will see in the conclusion of this article, you may be able to collect in excess of 9% annually in cash while holding Johnson Controls. You may also get paid 8% to 10% on cash in your account while you wait for a better price. If you find the returns mentioned in this article intriguing, I suggest that you take the time to understand the full strategy by reading that prior article.
I should point out that I make use of options, but in a very conservative fashion. Approximately 83% of all options contracts expire worthless. That is why I do not recommend, as part of this strategy, to buy options. I only sell options myself because that is the side of the contract that wins 83% of the time. I like the odds to be in my favor.
But I also don’t sell options just because of the odds, I do so with a purpose: To buy great stocks with rising dividends at a discount and to collect extra cash income while I hold those same stocks long-term. My objective is to create at least 8% per year in cash payments from a combination of dividends and option premiums each year in addition to the long-term appreciation that quality stocks provide. I believe that a 15% total return is achievable and that is what I intend to demonstrate over the next two years with this series. I should also remind readers to never, ever sell put options on a stock that you don’t really want to own. If it’s a stock that you would buy anyway, great; otherwise don’t fool with it.
On October 6, 2011, the price of JCI stock was $28.96. We sold one November put option on JCI with a strike price of $25 that paid us a premium of $1.20 per share (one contract equals 100 shares) or $111 net after the $9 commission. If the price had dropped below the strike price of $25 and stayed there through the November 18 expiration date, we would have been obligated to buy 100 shares of JCI at $25. But since we sold the put option and collected a premium of $1.20 we would have had a cost basis of $ 23.80 ($25-$1.20). Since the stock held up and the put expired worthless we got to keep the premium for a return on the cash we held as security in our account ($2,500) of 3.8% in just over on month. We earned an annualized rate of return of 23% (to understand how I calculated the annualized return please refer to the initial article for a detailed explanation. It is actually a very conservative method).
But now we still have the cash in our account and it’s time to sell another put. My favorite put option for JCI right now is the April 2012 $30 strike price put with a premium of $2.30. If put the stock we would be obligated to purchase 100 shares of JCI stock at $30 per share but would end up with a cost basis of $27.70 ($30 - $2.30). I like that price much better than the current price of $30.65 (all premiums and prices as of the close on December 28, 2011). If the option expires worthless we keep the $2.30 less the commission of $9 for a return of nearly 7.4% over less than four months. That works out to an annualized return of 22.1%. I don’t mind not getting the stock as long as I can make over 20% on cash sitting in my account.
There were two other options with shorter durations that would have provided similar annualized returns. The reason I didn’t select one of them is that I try to balance my decision between two primary factors, return and discount. This expiration offered enough of a discount incentive for me to choose it over the others. Of course, I also consider the cost of commissions or friction of the trading as well. If I can make the same rate of return for four months as I can over two months I prefer to lock it in over the four months because there is more certainty to maintaining the rate of return longer and less commission cost involved. I also prefer to buy multiple contracts when possible, but the restraints I have placed upon the portfolio combined with the diversification needs do not allow me to buy more than one in this instance.
I hope readers are enjoying the series and that you are just as interested to see how this experiment all turns out over the next two years. One last caution and I already said this once in this article before but I feel it is important enough to repeat. Unless you really, really want to own a stock don’t sell puts on it. Selling puts on stocks because of the premiums available only is the worst way to make a decision and usually ends up losing money. I use stocks in my strategy that I like and want to own for the long term.
I wish you all a healthy and prosperous New Year.