By Mark Bern, CPA CFA
I've been burned with options, as have many before me and many more yet to come. So, I try to stay on the winning side of the trades. I've read over and over that over 80 percent of all options expire worthless. That means, quite simply, that the buyer loses and the seller wins 80 percent of the time options are traded. I don't know about you, but I'd rather win 80 percent of the time and I'd like returns on my investments in excess of 10 percent annually. Well, let me explain how I use stock options contract to do just that using Walgreen (WAG) as an example.
First of all, I only sell options contracts for the obvious reason noted above. Granted, a number of those "losing" contracts were a part of spread trades where one side is supposed to lose as its primary purpose is to reduce risk and prevent large losses. But the sell sides of those transactions were still the winners. What I do, in the simplest of terms, is to use options writing as a substitute for placing limit orders for stock. But there are two differences: even if the price temporarily drops below my target price, I may or may not get the stock (I'll explain that in more detail later); and no matter what happens I get to keep the premium I received when I sold the put option of the stock. I like getting paid to place limit orders for stocks.
Before I get into the example with Walgreen, I want to mention to those readers that if you don't understand options or the terminology please don't go out and try to use this strategy without learning more and practicing by making paper trades (make believe trades kept track on paper) for a few months. To learn more about the strategy and about the terminology, please refer to an earlier article I wrote about a seven months ago.
That was the beginning of a series that I am still writing regularly with updates and periodic summaries showing how the strategy is doing against a similar buy-and-hold portfolio and against the S&P 500 Index. Don't forget to scroll down at the end of the article and read the comments from other readers. There is a wealth of additional information in that thread from many others investors who have been employing this strategy successfully for years.
As I begin the example I need to stress that an investor should never use this strategy on the stock of a company unless the investor really wants to own the stock. It could happen. And the premise of this concept is that I have done my due diligence homework on Walgreen and believe the company to be well-managed, to have excellent long-term prospects for growth, and that it will continue to increase the already solid dividend annually for many years to come. To understand my thoughts on Walgreen in greater detail, please refer to an article I published around the time that the company parted ways Express Scripts. I like Walgreen for the future and I really like collecting the options premiums every few months while I wait to buy the stock at a discount from the current market price.
Now we need some ground rules. Rule number one is worth repeating: never sell a put option on a stock unless you want to own the stock. My second rule is that I like to sell puts with premiums that offer me a return of one percent per month or better and a discount from the current price of between five and ten percent. My third rule is to try to find the best balance between discount and return without getting too greedy. My fourth rule is to compare annualized rates of returns to keep comparisons easier to follow. And, of course, as with any investment, never put too many of your eggs into any one basket. In other words, always diversify your portfolio so that no more than 10 percent (preferably less than five percent) is in any one investment.
Finally, here is the example. On Friday, May 11, 2012 the closing price for Walgreen was $33.24. The 52-week high was $45.34 and the 52-week low was $30.34. First off, I believe that all the bad news related to the Express Scripts divorce is already in the stock price as evidenced by the stock having languished in the $30 - $35 dollar range ever since the announcement.
Next we'll take a look at the available put options on Walgreen stock. I focused on the contracts with a strike price of $33 because the premiums on the lower strike prices were too low to consider. My favorite cash-secured put contract to sell is the July put option with the $33 strike price and a premium of $1.49 per share. In other words, if we sell to open a new position (or write to open, as different brokerage systems use different terminology) in this contract we would collect $149 (minus the commissions, I pay $8.50 for the first contract and $1.50 for each additional) and give the buyer the right to put (sell) the stock to us at any time prior to the July 20, 2012 expiration. We would need to secure the put (thereby the term cash-secured put) cash in our account during the holding period totaling $3,300. The return on that cash is 140/3,300 or 4.24 percent (I subtracted out the commission first) over a holding period of just over two months. If you annualize that return it becomes something close to 22 percent. And this happens without even owning the stock.
If the buyer of the option exercises the option we would be obligated to purchase 100 shares of Walgreen at $33 per share. But our cost basis would be only $31.51 ($33 - $1.49) because we already received and get to keep the premium. At that price, we would have purchased the stock for just 3.9 percent above the 52-week low.
Now is a good time to make a play on Walgreen, in my opinion. I intend to do so myself this coming week. As always, I enjoy the comments and will attempt to answer any questions readers may have.