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By Mark Bern, CPA CFA

We've tried selling puts only once before on Spectra Energy (NYSE:SE) and the contract expired worthless, but we did collect the premiums on the put 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 this excellent company's stock and then I will provide my most current recommendation based upon the closing quotes on Wednesday, April 25, 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 earlier article on SE here, you will recall that I believe that SE is a well-managed company with exceptional long-term potential. My reasoning is explained in greater detail in the first article (linked above).

In that article, when I first recommended SE on October 3, 2011, the stock price stood at $24.14. The April 25th closing price was $30.04. 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 it fares 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 3, 2011 we sold one November SE put contract with a strike price of $23 for a premium of $0.85 The option expired worthless and we pocketed $76 (net of commissions) for a return of 3.3% on the $2,300 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 SE at $23 a share which would give us a cost basis of $22.15 ($23 - $0.85). That would have been a discount of 8.2%. But the contract expired worthless, so all we got to keep was the premium of 3.3% over a holding period of less than two months.

I want to sell a put option on SE with an expiration of December 21, 2012 and a strike price of $30 for a premium of $2.40. That will provide approximately 7.7% over the next eight months, a little lower than what I prefer but still within a reasonable range for this stock. This equates to an annualized return of about 11.5%. If the contract is exercised before expiration we will be obligated to purchase 100 shares of SE at $30 per share for a cost basis of $27.60 ($30 - $2.40). I realize that this is well above the price we could have paid back in September and on a single stock basis we would 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 strategy is difficult to employ with SE because the premiums are often too low and the volume of contracts traded is lower than I would like. By December I may have a better alternative to use in the series going forward from that point. It will be hard to replace the potential of a 3.7% dividend yield.

As is my custom I believe that it 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 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.

Source: Updated Enhanced Income Strategy For Spectra Energy

Additional disclosure: I may sell puts on SE over the next week.