By Mark Bern, CPA, CFA
Occidental Petroleum (OXY) stock remained above our target price in our first attempt to purchase the stock through the use of our strategy. Those who read my first article on OXY will recall that we picked up $401 profit in just over two 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 nearly 27.7 percent. 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 OXY in the next few months. The other stock we are using in this series for exposure to the energy sector is Chevron (CVX).
Let me begin with the detailed explanation of the strategy from my original article that I used to initiate this series. As you will see in the conclusion of this article, you may be able to collect in excess of nine percent annually in cash while holding OXY stock. You may also get paid eight to ten percent on cash in your account while you wait for a better price.
I should point out that I make use of options, but in a very conservative fashion. Approximately 83 percent 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 percent 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 eight percent 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 percent 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 5, 2011, the price of OXY was $75.72 (all prices and premiums quoted are as of the close of the market on that day). We sold a November put with a strike price of $72.50 for a premium of $4.10. We received the $410 (one contract equals 100 shares; $4.10 x 100 = $410) less the commission of $9 for a net of $401 return on cash in our account held to secure the put option contract until expiration of 5.5 percent. That works out to an annualized return of 27.66 percent. (These numbers are slightly different from the first article on OXY, since I used the stock price instead of the strike price to calculate, and didn’t use my own methodology for annualizing the return.)
Had the stock price dipped below $72.50 and held there through the expiration date, we would have been put the stock, or obligated to buy 100 shares of OXY at $72.50. That would have resulted in a cost basis of $68.40 ($72.50 less the premium of $4.10). Not bad considering that the price of the stock on the day we entered into the trade was $75.72. But we didn’t get put the stock, so we need to put that money, plus our gain, back to work again.
Right now I like the January 2013 $85 strike put option contract with a premium of $10.95 ($1086 net of commission) which provides us with a simple return of 12.78 percent on the trade over the next 12 months. I only need one contract to balance our portfolio’s diversification. When we annualize the rate we find that we have locked in a 12.78 percent return on our cash.
If the stock drops below the strike price of $85 at expiration we will be obligated to purchase 100 shares of the stock at $85 per share. This means we will need $8,500 of cash in our account to secure the contract. Our cost basis would be $74.05 ($85 - $10.95). This is still below the price we would have paid on the original trade date back in October of $75.72 and substantially below (21 percent discount) the current price of $93.70.
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 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. The stocks I use in my strategy are those I like and want to own for the long term.