Strangling Profit From CMI

| About: Cummins Inc. (CMI)

Today's multiple choice question is: What is a "covered strangle?"

A. A particularly aggressive WWF wrestling tactic in which a combatant seizes the throat of his opponent with gloved hands, after having failed to dispatch him by hitting him over the head with a chair or running him over with a monster truck.

B. A marital situation in which one spouse savagely garrottes the other, yet is awarded life insurance benefits on the grounds that the act rid the world of a lazy, self-centered, and parasitic presence. One hundred percent of the victims in these cases are husbands.

C. An options play in which an investor purchases shares of a particular company, and sells both calls & puts of the same company.

If you guessed "A": Back away from the Playstation, remove your tights and mask, and go get some fresh air.

If you guessed "B": The answer to the question that's crossed your mind is: Try State Farm, Allstate, or Fat Tony's Insurance Emporium.

The correct answer is "C". If a covered strangle was a mixed drink, it would be a covered call with a short put chaser.

The suitability of a particular stock for a covered strangle depends on an investor's objectives and risk / reward profile. Conservative, buy-and-hold investors may seek to squeeze a bit of extra income from their portfolio, while minimizing the risk of having their shares called away or having new shares put to them. This type of investor might choose to sell moderately out-of-the-money, medium- to long-term calls and puts of a blue-chip, low beta company that trades within a narrow range, such as Johnson & Johnson (NYSE:JNJ). Here's an example of a JNJ covered strangle:

Buy 200 shares of JNJ for $64.74 on Mar 12 2012
Sell 2 Oct 19 2012 $70 calls for $.67
Sell 2 Oct 19 2012 $57.50 puts for $1.37
If JNJ closes between $57.50 and $70 on October 19:

  • Gross income $408
  • Gross annualized yield 5.20%

More aggressive investors may choose to compress the strike prices, shorten the option duration, and / or select more volatile stocks, in order to generate higher returns while assuming a greater risk of share assignment. I fall into this category of investor, and a stock that I love for a covered strangle is Cummins (NYSE:CMI).

CMI offers option sellers the best of both worlds: It is an extremely solid company that has earned a coveted 5-star rating from Standard & Poors; yet, as a cyclical stock it is prone to dramatic price swings as reflected by its 2.0 beta. CMI's price instability boosts both the call and put premiums, which generates attractive yields from both legs of a covered strangle, as the following example shows:

Buy 200 shares of CMI for $118.793 on Mar 12 2012
Sell 2 June 15 2012 $130 calls for $3
Sell 2 June 15 2012 $105 puts for $3.80
If CMI closes between $105 and 130 on June 15:

  • Gross income $1,360
  • Gross annualized yield 21.97%

Note that the JNJ and CMI puts and calls are equivalently out of the money (8-9% on the calls, 11-12% on the puts), yet the CMI trade delivers significantly higher yield than JNJ.

CMI has been on a tear since January, rising from $85 to $119, so is vulnerable to an especially sharp pullback if the market turns. Also, CMI reports earnings on May 1, which could lead to further volatility. Buckle up!

Disclosure: I am long CMI. I am short CMI calls and puts.