It's Time To 'Sell' This Market

|
Includes: AAPL, BA, CAT, MRK, TGT
by: Parsimony Investment Research

Summary

It's been a crazy start to the year for equities, but the volatility is not done.

Investors should remain calm through the volatility and focus on finding great stocks at good prices.

A cash-secured put strategy (selling puts) will help you generate income on idle cash with a built-in margin of safety.

It's been a roller coaster start to the year for equities and many investors are struggling to find their way. Rightly so. We keep jumping back and forth between a "good news is good news" environment and a "bad news is good news" environment. On any given day, its hard to tell whether a positive (or negative) economic or company earnings report is good (or bad) for stocks.

As highlighted in the charts below, the major equity indices have traded in a range for almost two years now - with the 8/24/15 lows (red lines on chart) serving as the bottom of the range and some recent psychological levels for each respective index serving as the top of the range (green lines on chart). While we did test the bottom of this range recently, the market has bounced nicely from that level of support.

That said, without a major catalyst, we believe that stocks will continue to trade in this range. While the U.S. economy appears to be stabilizing, the volatility in oil prices is likely to continue and central banks around the world are still very much in an "easing" type of mood.

While the test of the low end of our range (and subsequent bounce) was positive, investors should still remain cautious in the coming months to make sure this support level will hold.

We want to see positive economic news or corporate earnings drive stocks higher...not quantitative easing.

So what is a long-term income investor to do at this point?

The short answer is...SELL (puts)!

The pullback has already offered some great sales in some fantastic stocks, but prices could always go lower.

This article highlights a cash-secured put selling strategy. We often use a cash secured put strategy to generate income while we patiently wait for the "Buy Zones" on high-rated stocks that we are stalking (i.e., stocks we would love to own at a cheaper price).

Generating Income in a Down Market

We think that selling cash-secured puts on high-quality dividend stocks is a great strategy for an income investor in a down market. It allows investors to generate income while mitigating downside price risk. Cash-secured puts essentially act as a limit order for dividend stocks you want to add to your portfolio (but you get paid to put the order in!).

If you sell a put, you have an obligation to purchase the stock at a predetermined price (strike price) on or before the expiration date (if the buyer of the put option wants to sell you the stock). Clearly, the risk is that the stock drops significantly below the strike and you are forced to buy the stock at a price well above market.

Here are our two risk management rules of put selling:

  1. Only sell put options on stocks that you want to own at the price you want to own them - With a put selling income strategy (focused on out-of-the-money puts), you get paid to wait for the price you want on a stock. If the price never drops to your strike, you get to keep the premium (income) as a consolation prize. Your downside is owning the stock at the strike price (keep that in mind as you analyze the ideas below).
  2. Don't sell "naked" - Just because options offer you leverage, it doesn't mean that you have to use the leverage. We recommend securing your short put position with cash (i.e., don't sell on margin). If you aren't willing to risk the cash to back it up ... don't sell the put!

The two main things to focus on when considering a cash-secured put opportunity are Premium Yield and Margin of Safety.

  • Premium Yield (%) - The premium yield is the expected return on capital assuming that the option expires worthless (out-of-the-money).

Premium Yield % = option premium / (strike price - premium)

  • Margin of Safety (%) - Margin of safety is the percentage that the underlying stock could decline that would still allow you to break-even on the option trade.

Margin of Safety % = (stock price - break-even price) / current stock price

Note that there is always a negative correlation between Premium Yield and Margin of Safety: The higher the Premium Yield for a given strike month, the lower the Margin of Safety.

Choosing the Right Strike

Choosing the right strike price in a put selling strategy, like any investment decision, comes down to risk and reward. All else being equal, as your margin of safety (your cushion between the current stock price and your strike price) decreases, your premium yield increases (because the risk that your option will be exercised increases).

Ideally, we like to choose a strike price where the break-even price of the option trade will be close to or in our "Buy Zone" for that stock. In addition, we prefer utilizing options with expiration dates that are at least 3-6 months out to reduce trading costs. Note that the annualized option premium yield can oftentimes be approximately equal to the dividend yield on the stock. So you can essentially generate the same income without the downside risk.

Screening For Good Candidates

Below are the main factors that we use to screen for good cash-secured put candidates:

  • High Quality Dividend Stocks - First and foremost, we only recommend selling puts on dividend stocks that you would feel comfortable owning (if the put is exercised). Every investor should have a process in place for identifying stocks that fit your investment strategy. Note that we utilize our Parsimony Ratings to identify the best dividend stocks (our ratings are based on 30 key fundamental and technical data points).
  • Minimum Option Volume - Unfortunately, all stocks do not have actively traded options. We try to focus on options that have a minimum open interest of 100 contracts.
  • Stocks In (or Near) the "Buy Zone" - The best time to write a put on a stock is after a decent pullback as there is typically a good tradeoff between risk (further downside in the stock) and reward (premium yield). Ideally, we like our option break-even price to be in or below our "Buy Zone" for that stock (which is the price we would feel comfortable owning the stock).
  • Upcoming Catalysts - As highlighted above, near-term earnings announcements and other potential catalysts could cause implied option volatility to spike, which typically results in higher option premiums. Since we are selling a put option, higher premiums are preferable. That said, it's very important to understand why the options are pricing in higher volatility so that you don't get caught off-guard on the downside. You may want to consider an option with a higher margin of safety if you are concerned about further downside pressure.

Here is a list of stocks that we have recommended cash-secured put trades on recently to give you an idea of the type of high quality dividend stocks that we have targeted. Remember you only want to write a put on stocks that you would like to own (at the right price, of course). Keep this in mind as you are looking for opportunities.

  • Apple (NASDAQ:AAPL)
  • Boeing (NYSE:BA)
  • Caterpillar (NYSE:CAT)
  • Merck & Co. (NYSE:MRK)
  • Target Corp. (NYSE:TGT)

Let's look at a real-time example of a trade that were sent around to our Triple Income Portfolio subscribers earlier this afternoon:

Click to enlarge

Our "Buy Zone" for Target Corp. is currently $68.00-$74.00 As such, we recommend selling the Mar16 $67.50 put, which equates to a $65.50 break-even price (i.e., net purchase price if exercised) and a premium yield of 3.1%! This trade has a margin of safety of 6.4% and you can collect income equivalent to ~100% of Target's 3.1% dividend yield in less than 2 months!

With Target set to report earnings on 2/23/16 (before the expiration of this option), we decided to do a short-term option trade to take advantage of the higher than normal implied volatility in the option premium. The risk/reward trade-off here is fantastic as we would be more than happy to buy Target if the stock dropped to our strike price of $67.50.

Target currently trades at a discount to several of its long-term average trailing valuation multiples (P/Earnings and EV/EBITDA). In fact, after today's selloff, Target is trading around 14.5x forward earnings, representing a 15% discount to its 5-year average P/E. At the net breakeven price of the put trade ($65.50), the valuation of your position would be 13.5x forward earnings. Which is just downright silly cheap for a company like this.

From a dividend perspective, the Company has one of the highest Dividend Ratings (97) in our coverage universe. Target pays a decent dividend yield of 3.1% and has increased its payout to shareholders at a compound annual rate of 20% over the past 10 years! In addition, the company still has a payout ratio below 50% and we believe Target's dividend will be safe through the earnings cycle.

Summary

Income investors should not be fearful of a pullback or a correction. A market pullback is the best time to buy great stocks on sale. In our opinion, the best way to prepare for a market volatility is to make sure you have a list of stocks you want to buy as well as the price you want to buy them. If you have properly diligenced these stocks (and Buy Zone prices), you'll be prepared to "buy the dip" when it happens and with a cash-secured put strategy you can build in a nice margin of safety.

Disclosure: I am/we are long TGT, AAPL, BA, MRK, CAT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.