Updated Enhanced Income Strategy For Blackrock And Applied Materials

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 |  Includes: AMAT, BLK
by: Mark Bern, CFA

By Mark Bern, CPA CFA

We've tried selling puts twice on both Blackrock (NYSE:BLK) and Applied Materials (NASDAQ:AMAT) and thus far have seen those contracts expire worthless. But we did collect the premiums on the puts we sold. But that is part of the strategy: Earn cash returns of at least 8% per year (preferably 10-12%) until we get the stocks at discounts to the current market price. In this article I will start by reviewing the results of what we have done thus far with these two excellent companies' stocks and then I will provide my most current recommendations based upon the closing quotes on Tuesday, April 24, 2012. Generally articles are published within 24 hours of submission so the recommendations in my articles should still be close to what is available in the market at the time of publication. I try to always use closing prices because that reduces the opportunity to "cherry pick" the best prices of the day.

For those who read my previous article on BLK here, you will recall that I continue to believe that BLK is a well-managed, dominant company with exceptional upside potential. I like the long-term prospects for BLK and consider it a good long-term holding. My reasoning is explained in greater detail in the first article (you can link to the earlier article from within the article linked above).

In the first article, when I first recommended BLK on October 20, 2011, the stock price stood at $152.16. The April 24th closing price was $188.57. At this juncture, the argument can certainly be made that we should have just bought the stock at the time. The same can be said for many of my recommendations in this series. But the true measure of the strategy will be how portfolio returns fare relative to the buy-and-hold strategy over time. I periodically write summary articles for this series that compared the returns of both so readers can see how things are going as time passes.

On October 20, 2011 we sold one BLK November put contract with a strike price of $140 for a premium of $3.10. The option expired worthless and we pocketed $301 (net of commissions) for a return of 2.2% on the $14,000 we held in our account to secure the put contract. Had the contract been exercised we would have been obligated to purchase 100 shares of BLK at $140 a share which would give us a cost basis of $136.90 ($140 - $3.10). That would have been a discount of 10%. But the contract expired worthless, so all we got to keep was the premium of 2.25% over a holding period of about one month.

Then, on January 2, 2012, we sold another put contract, this time with an expiration in April 2012 and a strike price of $160 for a premium of $7.80 per share. We collected $771 (net of commissions) and held the position for three and a half months for a return of 4.8%. So, thus far we have collected a total of 7% on BLK without holding the stock. Had this option been exercised we would have been obligated to purchase 100 shares of the stock for $160 a share and a cost basis of $152.20 ($160 - $7.80). The contract expired worthless once again so we need to make another attempt and reap the rewards of being paid while we wait yet again. I'll make my recommendation later in this article.

But first, let me review what we've done with AMAT to date. You can access the previous update on AMAT here and proceed back to first article through the ink provided in the previous article. We have sold puts on AMAT twice and both time the contracts have expired worthless allowing us to retain the option premiums as a return on the cash we held in our account to secure the puts.

In the first article I explained in detail why I like AMAT as a potential long-term holding. The stock price then stood at $10.75 a share and recently stood at $11.49. I maintain that AMAT remains a well-managed company with excellent upside potential, a dividend that just keeps on rising year after year, and one that I still want to own for the long term.

We sold the first put option contract on AMAT October 10, 2011, with an expiration in January 2012 and a strike price of $10 a share for a premium of $0.68, or $59 (net of commission). That would have been a 5.9% return on the $1,000 cash we held in our account to secure the put for a holding period of just over three months. Of course, if the contract had been exercised we would have been obligated to purchase 100 shares of the stock at $10 per share. That would have given us a cost basis of $9.32 ($10 - $0.68). But I opted to "roll" the position by buying back the original contract at a premium of $0.29. So, after commissions we netted only $21, or 2.1% over the two months we held the contract.

On December 12, 2011 we bought back the original contract and sold four more put contracts, this time the options would expire in April 2012 with a strike price of $9.00 for a premium of $0.40 per share. The primary reason for the position roll was to increase the number of contracts for better diversification balance in the portfolio. We collect a total of $146.50 (net of $13.50 commissions) for a return of 4.07% over a holding period of four months. Had the options been exercised we would have been obligated to purchase 400 shares of AMAT at $9.00 per share and a cost basis of $8.60 ($9 - $0.40).

Today I want to sell a put option on BLK with an expiration of June 15, 2012 and a strike price of $180 for a premium of $4.60. That will provide approximately 2.5% over the next two months. If the contract is exercised before expiration we will be obligated to purchase 100 shares of BLK at $180 per share for a cost basis of $175.40 ($180 - $4.60). I realize that this is well above the price we could have paid back in October and on a single stock basis we may have been better off just buying the stock back then. But this whole exercise in one in portfolio strategy where we need to look at the reduced risk of holding a diversified equity portfolio and measure success on the basis of return on the whole portfolio over time. Only time will tell if this strategy holds merit over buy-and-hold.

The next recommendation I want to make is to sell four AMAT put option contracts that expire on July 20, 2012 with a strike price of $11 for a premium of $0.42. That will net us $154.50 after commission for a return of 3.5% on the $4,400 cash we will hold in our account to secure the put over a holding period of three months. If the option is exercised we will be obligated to purchase 100 shares of AMAT at $11 per share resulting in a cost basis of $10.58 ($11 - $0.42.

As is my custom I believe that is important that I 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% or more usually one or more times 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% on average) annually while they wait. Granted, that is not as good as hitting a 30% 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% 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%, they would be down 50% 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% along the way, putting them down 25% at the bottom. Remember, you bought at 10% below the top, using puts, so you couldn't lose the full 50% 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% 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% 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% above the stock price at the time the option is sold; therefore you should be selling at no less than 10% off the bottom. That would result in a total of a 15% 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 the 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.

Disclosure: I am long AMAT.