By Mark Bern, CPA CFA
We've tried selling puts on Intel (INTC) twice before and have seen those contracts expire worthless, but we did collect the premiums on the puts we sold. Recall from my first article on Intel that the stock price was $21.94 (all prices and premiums quoted as of the market close on September 21, 2011) while the premium on the October $20 strike Put was $0.28.
We collected $28 ($0.28 x 100) on the 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 leaves us will $19 net of commissions which represents a return of .87% for 37 days. If you annualize that return you will come up with about 8.8% without owning any stock. Not great, but not bad either.
On our second attempt we sold 2 February put contracts with a strike price of $23 and collected a premium of $0.97 per share or $185 (200 shares x $0.97 less commission of $9). That gave us a return of about 4% on the $4600 cash we held in our account to secure the put contracts.
For those who read the earlier articles on Intel here and here - if you recall, I believe Intel to be a well-managed, dominant company with exceptional upside potential. I may not have said it in those exact words, but there you go. I like Intel a lot and think that it is a great investment for the long-term. At its current price of $27.45 (all current quotes in this article were taken after the market close on Monday, April 23, 2012); I believe that the company still represents a good value.
However, with all the uncertainty in the market today, I think the volatility will give us an opportunity to buy this company at a better price. I do expect that the markets will continue higher until fall due to continued Fed intervention(s) and the added spending that occurs in an election year (and the spending this year should break all previous records). If externalities should shake the economy, such as new scares in Europe or conflict in the Middle East, then all bets are off. Assuming no shocks, the economy and market should continue to grind their ways to higher levels throughout most of the year. Remember: market corrections are buying opportunities.
I know that many of my readers are going to question my reasoning for my choice of contracts this time so I'll try to do a better job of explaining myself in the article this time instead of waiting to address the issue in the comments. I usually favor short-term maturities and have strayed a bit from that, mostly to provide a variation of the strategy for readers to consider as we travel along through the series. But this time I have what I feel are very good reasons to select a long-term put option contract as I will explain in a moment.
My favorite put options contract to sell on Intel today is the January 2014 $30 strike selling for a premium of $5.85. I will sell two contracts and collect a total of $1,160 (after commission of $10; I changed brokers and this is the actual cost for me now. You may do better or slightly worse but this seems to be a good example of what is available without negotiating lower rates). That provides me with a return over the next 21 months of a 19.3%, or an 11% annual rate. If the contracts are exercised at any time between now and expiration I will be obligated to purchase 200 shares of Intel at $30, but will end up with a cost basis of $24.15 per share ($30 - $5.85).
Now I'll provide my explanation to reduce the number of comments (hopefully). Intel puts have rarely offered much better than 10%; today the shorter expirations are trading at annual rates of 6.3-8.9%. Second, I'll lock in that return for a longer period and reduce my trading expenses. Third, I like collecting over 19% on my money up front. Fourth, I really like Intel at $24.15 for the long term and would be willing to buy it there anytime over the next two years. Unless we have another market crash, ala 2008-09, I don't see any major downside. Even if we do have a crash, I assume that the price of Intel stock will recover to current levels and proceed higher over time and that the dividend increases will keep on coming.
Finally, if Congress looks like it will mess up the credit rating again this fall after the election, which it very well may because it will be faced with raising the debt limit during the lame-duck session, I believe that the market will have pushed to higher ground during the interim and that the premium will have decayed enough by then to still capture a better gain by closing the position in the fall than to have traded several shorter duration contracts over that same period. Time will tell. It should be interesting to watch this one.
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 10 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. If 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 10 percent above the stock price at the time the option is sold, therefore you should be selling at no less than 10 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.
As always, I enjoy the comments and will try my best to answer questions if readers will take the time post them.
If you are a new reader and are confused about what strategy I keep referring to please see the first article in the series for a primer. You can find it at this link.
Thanks for reading and I wish you all a successful investing future!