By Mark Bern, CPA CFA
We have sold three puts on Applied Materials (AMAT) in previous articles that can be found by linking backwards from the most recent article published in April on this company or by checking out "My Long-Term, Enhanced Investing-For-Income Strategy Discussion And Concentrator Blog" that I created for this series that lists links to all articles published. In April, we sold four AMAT put options expiring in July 2012 with a strike price of $11.00 for a premium of $0.42 per share. Today's article is going to provide guidance on how to protect a position in a falling market by rolling the option to a more distant expiration.
I am not taking action because I don't want to own AMAT stock. I want to be clear on this point. But the turmoil in Europe, the stumbling U.S. economic recovery, and slowing growth in emerging markets may be sending us a signal that equities could fall lower in the near term. If AMAT were to fall below $10, I would rather own the stock with a cost basis of $10 or less rather than closer to $11. That is all that this is about: trying to improve our entry point in a quality stock to build a long-term position.
So, what I want to propose is something a little different but, I think relevant, during times as crazy as we are experiencing now. I want to buy back our four contracts at the current premium quoted of $0.35 per share (as of 1:09 p.m. on Monday, June 25, 2012); the bid/ask prices are $0.33 and $0.34, respectively, but the last trade was made at $0.35, so I am taking the worst quote of the three to be as realistic as possible. This trade will result in our paying an additional $13.50 in commissions and end up with a very minimal gain of $1 (Initial Premiums collected of $168, less total commission of $27 for both transactions, less the premiums paid to buy back the puts of $140 = $1).
Now, what I want to do is sell 4 new puts that will give us a better entry point if exercised and plenty of time to expiration in case the market bottoms sooner so we can take a profit and roll into another closer expiration put, possibly in the money at that time, and to basically give us more flexibility in volatile times. The contract I like today is the January 2014 put with a strike price of $10 and a premium of $1.54 (as of 1:18 p.m. on June 25, 2012; the bid/ask/last quotes are $1.54/$1.59/$1.58, respectively, so again I am taking the worst quote available at the time). The APR is lower than I would like, at 9.3 percent, but it is still acceptable under the circumstances. If exercised, we would achieve a cost basis of $8.46. This is what I am focusing on today. If the market were to crash, we could end up with a quality stock for the long term at a much better price than if we had stayed with the position from which we just rolled out. This is a precautionary move to demonstrate that this strategy does have deviations that can be employed to protect ourselves during scary market conditions.
I considered making a similar move on Colgate-Palmolive (CL), but the strike price of $80 on the existing put we sold earlier would make a better entry than just about anything we could find in today's market. The lesson here is that when the stock price is close to the put option strike price for a contract we have already sold, a little analysis makes sense to determine the best course of action. It may be better to hold tight and allow the option to be exercised or it may be better to roll the contract to a later expiration for greater flexibility. Much depends upon current market conditions and what an investor believes is the potential for the underlying stock. At the current time, it appears to me that AMAT's business could be remain slower than normal until the global economy gets back on track and demand in the semiconductor industry improves, requiring new equipment from AMAT. Eventually, the cycle will turn and AMAT, because of its leadership position, will benefit. The company is well positioned to ride out the storm, but if I can get a lower entry price or protect my cash while improving my return, it seems prudent to me to make this move.
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 which contains a detailed explanation of the complete strategy as well as a couple of examples. The comments following that article are also very educational.