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By Mark Bern, CPA CFA

We didn't buy puts on any of these stocks on the first or second tries, but we did collect the premiums on the puts we sold. Recall from my first article on Union Pacific (NYSE:UNP) that the stock price was $85.22 (prices and premiums quoted as of the market close on September 29, 2011), while the premium on the November $77.50 strike Put was $2.64. We collected $264 ($2.64 x 100) on one contract that we sold, but we also paid a commission of $9 (assumed amount that is about the average of discount brokerage premiums; you can do better if you shop around).

That left us with $255 net of commissions, which represents a return of 3.3% for 42 days. If you annualized (using the method that I explained in detail within my first article in the series) the return you would come up with is about 32.9% without owning any stock. Not bad if we can maintain this level of return. I really don't care if I own stock or not if I can get a return like this consistently, but I don't think that we are likely to fair this well regularly over the long-term. Something more in the range of 8-12% may be achievable over the long haul. Returns will be less during more normal economic times, with less volatility than we have been experiencing as of late.

In the second UNP article we sold the second put option on UNP-- the price of the stock was $100.38 on November 10, 2011. The strike price was $90 and the premium was $3.00. We collected $300 (less the commission of $9) for a return of 3.26%, or 32.6% annualized. Again, this was a very good return for such a short return of two months. Had we been put the stock, our cost basis would have been $87 ($90 - $3) representing a discount of 13.4%.

For those who read the first article on UNP, you will recall that I believe the company to be well-managed, and geographically dominant within the rail industry with good upside potential. It also pays a nice dividend to boot. I like UNP and think that it is a great investment for the long-term. At its current price of $107.64, I believe that the company is fairly valued. It does not represent the bargain that it did in either of the first two articles, but it is still worthy of consideration by a long-term investor with growth and rising dividends as their goals.

My favorite put option to sell on UNP at the moment is the April put with a strike price of $100 and a premium of $1.21. After the commission you are left with $112 and a return of 1.0%, or about 10% on an annualized basis. The exercise date is April 20, 2012, so you earn the 1% in just over one month. Not a bad return on cash these days. If the option is exercised and we get put the stock, we will have a cost basis of $98.79 ($100 - $1.21).

We still don't own UNP stock, but since the end of September of last year (approximately 5 ½ months) we've collected premiums totaling $667 for a return of 6.7% on the $10,000 we hold in our account to secure the put. Our annualized rate of return should turn out to be in the 12-13% range after the first year; right at the high end of our target.

Next, let's take a look at how we've done with Lowe's (NYSE:LOW). I proposed LOW in the first article of the series because I felt that the stock was severely undervalued. The stock price then (September 20, 2011) was 19.92 and is currently at $29.77 for a gain of 49% over the past 5 ½ months. I believe that my assumption about the valuation appears to have been correct, but what about the valuation today? It appears to be somewhat overvalued at this time. I have felt that way about the company ever since the price passed the $27 level. If I could get the stock below $27 I'd be happy. The best alternative to LOW is Home Depot (NYSE:HD) and its price is only slightly less overpriced, in my opinion. I believe that LOW has a little better growth prospect, so the slight premium isn't unwarranted. As such, I'll stick with LOW for now and see if I can find a put option to sell that could net me my target price.

But first I should take a moment to detail the results we've had on LOW thus far. In September 2011 we sold a November put option on LOW with a strike price of $18 and collected a premium of $0.33 per share, or $24 (after commission) for a return of 1.3%. Admittedly, since I included LOW in the original article (linked above) and the company name did not appear in the article title, I missed selling another put or two during the interim. I'll just have to make up for my negligence in the future, between now and September 2013 when I intend to conclude this series. Had we gotten put the stock we would have been sitting pretty with a cost basis of $17.67 a share ($18 - $0.33). Alas, it was not meant to be.

Today, my favorite put option to sell on LOW is the July put with a strike of $28 and a premium of $1.16. I need to sell two contracts to complete my diversification allocation in the services/retail sector. If the option contracts expire worthless, we will keep the premium net of commissions ($10.50) of $221.50 for a return of 4% in just four months or an annualized rate of return of 11.9%. That meets my return objective and allows me an opportunity to buy the stock, should the options get exercised, at a cost basis of $26.84 ($28 - $1.16), just below my target price of $27.

Finally, I also want to provide the last update on companies in the service sector, Walgreen (WAG). As many of you already know, WAG stock has not fared well of late because of the split with Express Scripts (NASDAQ:ESRX). I didn't anticipate the companies coming to terms, and felt that the stock offered investors an opportunity for the long-term. I remain convinced that management will work through the difficult period that faces the company over the next couple of quarters, but I also believe that the worst news is already built into the stock price.

The company has already lowered guidance for this quarter and the full year, but remains confident that a significant amount of the lost business can be regained through a number of smaller contracts with individual employers. I also believe that the company is well positioned to see its profit margin increase steadily over the next few years due to the reduction in low margin business from ESRX and the increased flow of generic prescriptions on which margins are typically much higher than on branded drugs.

Thus far we have sold two put option contracts on WAG and collected a total of $253 in premiums (net of commissions) for a total return of 7.67% over 5 ½ months. In the first article on September 29, 2011, we sold one November put option with a strike price of $31 for a premium of $119. In the 2nd article on WAG, on December 27, 2011 we sold one February put option with a strike price of $33 and a premium of $152. Both options expired worthless, but we have more cash now than we did when we started, we've collected more in premiums than we would have from dividends had we owned the stock, and the stock price still hasn't gone anywhere.

I believe there is still more opportunity to sell puts on this stock before the company gets fully back on track and Wall Street begins to reward it again. Quality management will see us through. With that in mind, my favorite put option to sell on WAG at the moment is the April put with a strike price of $32 and a premium of $0.70. We will collect 1.8% for just over a month of waiting, which gives us an annualized return of about 18% on this trade. If the option is exercised, we are obligated to purchase the stock for $32, which results in a 7% discount from the current price of $33.48 and a cost basis of $31.30 ($32 - $0.70).

I believe that I must include a warning in my articles in this series to make sure that everyone understands that there are risks to every strategy, including this one.

First, as has been pointed out in the comment threads to previous articles, there is always the possibility that the selling puts strategy may not result in the purchase of the desired stock in a rapidly rising market. An investor could miss most, if not all, of a run up. It is doubtful that the full run will be missed, however, since the market (including most stocks) correct by 10 percent or more usually once or more per year. For that reason it is likely that the investor will purchase the stock at some point during a bull market, but they still may miss some portion of it (perhaps a large portion, especially in a bounce off a major bottom).

On the positive side of this equation is the fact that as most major bottoms occur, there is usually a day of capitulation. Capitulation days are generally heavy down days on which-- if one has sold puts outstanding-- the investor stands a good chance of being put the stock (purchasing at the bottom). There are no promises of that happening, but the odds are better under this strategy than following one's gut emotions. One other thing that helps offset the possible regret of missing a stock at a good price is that the seller of the puts will continue to earn a decent return on their cash (generally 8-10 percent on average) annually while they wait. Granted, that is not as good as hitting a 30 percent gain in a good year, but it sure beats sitting in a money market and earning zip.

Second, as has also been pointed out in the comment threads, it is possible to end up buying a stock when the stock market tumbles and having to ride it out to the bottom. If the investor is buying a stock in a company that they want to hold for the long term, at least with this strategy they will never buy at the very top. After all, we're selling puts at below the price when the put option is sold. In addition, the investor has the opportunity to sell calls and, including dividends, receive an average of 8-10 percent in cash payments per year while they wait for the stock to rebound.

If we have done our homework in picking a good company at a price that represents a good value, then the likelihood of a rebound is very strong. Practically the only way to end up losing money is by selling the stock. If you hold, you're getting paid well to do so and eventually you'll be back in the money. If the investor had purchased the stock outright at the top of the market and the market fell 50 percent, they would be down 50 percent at the bottom and need the stock to double just to get even. If they are selling calls all the way down, assuming the average length on most bear markets is about 17-19 months, the investor should have collected somewhere in the vicinity of 15 percent along the way, putting them down 25 percent at the bottom. Remember, you bought at ten percent below the top, using puts, so you couldn't lose the full 50 percent in any event. Now you only need half as much of a rebound to get even.

The third scenario is the worst case. An investor sells a put near the top and ends up with the stock at a 10 percent discount from the high and rides it all the way down to the bottom, collecting dividends and call premiums along the way. Now you are down 25 percent and you end up selling a call that gets exercised near the bottom and the stock is called away. But remember, you are selling calls that will net you about ten percent above the stock price at the time the option is sold, therefore you should be selling at no less than ten percent off the bottom. That would result in a total of a 15 percent loss on the total of your transactions. Now compare that to most alternatives other than picking the tops and bottoms, which no one can do consistently.

An alternative to riding a stock down is to use stop loss limit orders. I recommend that investors consider using this strategy to save themselves the pain of riding a stock down during an overall market crash. Some long-term investors with a low cost basis may not want to use this strategy due to the tax consequences.

The point is, while this isn't the most lucrative strategy, it does bear less risk of loss than most alternatives. By taking most of the emotions out of the decision process, an investor improves their chances of producing consistently higher returns-- and that is the whole point. I hope this explanation helps cure some of the over-enthusiasm. This is no get rich quick scheme. It is simply a systematic strategy that can help investors achieve market-beating returns over the long term.

Disclosure: I am long UNP, WAG.

Source: Updated Enhanced Income Strategy For Union Pacific, Lowe's, And Walgreen