By Mark Bern, CPA CFA
We've tried selling puts twice before on Emerson Electric (EMR); the first time the contract expired worthless, and now the remaining contract trades at a premium of only $0.25 with about two months to expiration. Let's roll this position to collect a better premium over the next few months. We have already collected most of the premium on the existing contract and we did collect all of the premiums on the previous puts we sold. But that is part of the strategy: earn cash returns of at least 8 percent 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 Friday, April 27, 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 EMR, you will recall that I believe that, while the company seems fairly valued at the present, it is well-managed and has exceptional long-term potential. My reasoning is explained in greater detail in my first article about EMR.
In the first article, when I initially recommended EMR on September 30, 2011, the stock price stood at $41.31. The April 27th closing price was $52.68. 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 the whole portfolio 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 September 30, 2011 we sold one EMR November 2011 put contract with a strike price of $37.50 for a premium of $1.80. The option expired worthless and we pocketed $171 (net of commissions) for a return of 4.56 percent on the $3,750 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 EMR at $37.50 a share which would have given us a cost basis of $35.70 ($37.50 - $1.80). That would have been a discount of 13.6 percent. But the contract expired worthless, so all we kept was the premium of 4.56 percent over a holding period of about a month and a half.
Next, on January 2, 2012 we sold one EMR June 2012 put option contract with a strike price of $45 for a premium of $3.50. The option would not expire until June 15, 2012 but the premium has decayed to only $0.25, so I want to buy this one back and roll our position to create more return. In this instance we will still keep most of the premium, $307 out of the original $350 (net of commission) of premium income for a return of 6.82 percent. Had the option been exercised we would have been obligated to purchase 100 shares of EMR at $45 per share resulting in a cost basis of $41.50 ($45 - $3.50). Thus far we have collected about 11.4 percent return on our cash with. This falls above our parameters for achieving a goal return of at least 8 - 10 percent per year on our cash.
Today I want to recommend selling another put option contract on EMR to replace the one we just bought back above; this time the put will expire on September21, 2012 with a strike price of $50 for a premium of $2.25 a share. Our return, if the contract expires worthless, will be 4.3 percent over a holding period of about five months. That would bring our total return on our cash position to about 15.7 percent over the first year. That falls nicely above the parameters of our goals for the strategy. If the option we are selling is exercised we will be obligated to purchase 100 shares of EMR at $50 per share giving us a cost basis of $47.75 ($50 - $2.25). The discount to the current price is about 9.4 percent.
As is my custom I believe that it is important to 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 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 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.
Thanks for reading and I wish you all a successful investing future!