By Mark Bern, CPA CFA
We have sold only one put option on Freeport McMoRan (FCX) in a previous article published in December 2012. In December, we sold two January 2013 FCX put options with a strike price of $34.00 for a premium of $5.90 per share and collected $1,180 in total premiums ($1,169.50 after commissions). 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. This may seem like overkill since the expiration is still seven months away, but what we are protecting ourselves against with this move is the potential for deflation (in U.S. dollar terms) in commodities due to potential continued weakness in the Euro and sluggish demand from a slowing global economy. Bear with me and I hope this move will make sense by the end of the article. This is a lesson in capital preservation and increasing flexibility while adding some more cash to our coffers while we wait for a better buying opportunity.
I am not taking action because I don't want to own FCX 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. More importantly, if the Euro continues its decline in value, commodities that are priced in U.S. dollars will see prices fall. It may be a different story for investors in other countries whose investments are denominated in local currencies. Folks in the Eurozone could experience inflation at the same time that we in the U.S. experience deflation. In this article I am focusing on investments made in the US ADRs for FCX. If you have questions about my expectations for other currencies, please ask questions in the comments at the end of this article and I will do my best to provide what insights I can from my point of view. Of course, we are dealing with opinions based upon my readings, research and experience and nothing is guaranteed. But I'll explain my views as simply as I can and invite others to offer their counter views. We are, in the end, all students of varying levels in differing areas and can always benefits from differing perspectives.
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 two contracts at the current premium quoted of $5.65 per share (as of the close on Wednesday, June 27, 2012); the bid/ask prices are $5.55and $5.65, respectively, but the last trade was made at $5.50, 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 $10.50 in commissions and end up with a very minimal gain of $29.00 (Initial Premiums collected of $1180, less total commission of $21 for both transactions, less the premiums paid to buy back the puts of $1130 = $29).
Now, what I want to do is sell two new puts that will give us a better entry point (very critical element) 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 $30.00 and a premium of $6.55 (bid/ask/last quotes at the close are $6.55/$6.65/$6.65, respectively, so again I am taking the worst quote available at the time). We will collect a total of $1,299.50 in premiums (net of commissions). That equates to 20.1 percent of the cash required to secure the puts. The APR is excellent at 13.68 percent, but it is still not the true reason for making the transaction. If the new contracts are exercised, we will achieve a cost basis of $23.45, a full 27 percent discount to the current price of $32.14. Under the January 2013 contracts that we currently own, if exercised, our cost basis would be $28.10. 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 are rolling 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 am considering making similar moves on other positions, but I must perform the risk/reward assessment on each position before I make any more moves. The lesson here is that the stock price does not necessarily need to be close to the put option strike price for a contract we have already sold to make rolling a position beneficial. In some cases it may be better to hold tight and allow the option to be exercised while in others it may be better to roll the contract to a later expiration for greater flexibility. Much depends upon current market conditions at both the macro and micro levels and what an investor believes is the potential for the underlying company. Eventually, FCX will prove to be a great long-term investment and 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.
If you are a new reader and are confused about what strategy I keep referring to please see the first article in the series, "My Long-Term, Enhanced Investing-for-Income Strategy," 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. As always, I enjoy the comments and will try my best to answer questions if readers will take the time post them.