Our Long-Term, Investing For Increased Yield Strategy: Part 2

| About: Cummins Inc. (CMI)

Back to Part 1

By Timour Chayipov and Mark Bern, CPA CFA

This article will conclude our detailed explanation of the strategy to remove a portion of an initial investment in an equity position systematically each year until the full amount has been recovered and re-invested. This process will increase the overall yield of your portfolio over time. This is a long-term strategy to increase yield for retirement. But, it can also be used to increase current yield as well.

In Part 1, we bought 100 shares of Cummins Incorporated (CMI) at the market price at the time (Friday, July 6, 2012 market close) for $96.29. We also sold one CMI January 2014 put option contract with a strike price of $85 to collect a premium of $14.10 per share ($1,410 less commissions). We secure the put position by keeping $4,250 in cash or cash equivalent funds in our margin account. Next, we sold a January call option with a strike price of $115 to collect a premium of $10.10 per share ($1,010 less commissions). We have collected $2,420 in premiums to reduce our initial investment of $9,629 to $7,209, or $72.09 per share.

For the scenario results from the different possible outcomes, please refer back to the original article. We broke the article into two parts because it was getting too long and we would prefer to keep this article shorter by not repeating any more than necessary to set up what comes next. But before we go on into the discussion of rolling positions and additional potential outcomes, we would like to share a comment made by reader jammerculture that we feel captures the essence of why we write about the strategies as we do:

"Why I like a strategy like this:

"My rules require me to hold cash. Why? To add to positions in stocks I plan to hold long term when they are at a discount. The put writing is a way to make something from that cash. In the event of a substantial drop in share price the cash is already earmarked to add to my position. Taking the premium is a no brainer. Taking it twice is even better, especially since another one of my rules requires profit taking, even on core positions if a stock moves too far, too fast. I might as well sell the calls if I plan to sell anyway.

"It's amazing what happened when I adopted this mindset. I stopped fearing a drop in share price. I almost hope for it. I also don't necessarily look for big moves, because I can't trust the sustainability of such moves. The ebb and flow of market prices is irrelevant from an analysis perspective, it is the fundamentals that matter. My goal is to accumulate shares in the most powerful companies around, at the best prices possible, as long as they continue to remain powerful. This strategy allows me to free up more capital for this accumulation. I love the idea of in ten years extracting 100% of an original investment, coupled with the compounding of gains from every year's extraction, how could you not?. The long-term potentials for this strategy are mind boggling. I am seriously hoping to see more strategies that focus on capital extraction and reinvestment."

We believe that this comment encompasses the objectives of the strategy from another investor's perspective that it needed to be shared again for those who may have missed it since it came near the end of the comments to the previous article. Now, we move on to the objectives of this article. We will explain how and why we roll positions and what investors can expect from those efforts. The rolling of positions is a very important piece of the strategy because it allows investors to take advantage of market movements that provide either an opportunity to take profits early, improve the overall position for future profit or reduce the risk of the strategy. Shorter term movements in a stock's price, when overdone in either direction, provide opportunities when viewed correctly. Let's take a look at a few scenarios and outcomes.

In each of the outcomes detailed in the first part of this article, we explained one outcome for each scenario. The three scenarios were: the stock price rises to above out call strike price, the stock price falls to below our put strike price or the stock remains between the two strike prices. We explained in each scenario what would happen if we had simply held the position until expiration. But there is always at least one other choice: roll the option positions by closing out (buying back) the two original options that were sold and selling new positions further out, perhaps with expiration dates in January 2015. Of course, there is always the additional choice to buy back the options we originally sold and wait for another better price level for the opportunity to sell two more options (one put and one call) for better premiums. This last alternative is usually best applied when the stock has run up too far, too fast. In that case, we would take our profits and wait until the next time the stock price corrects again. But let's look at how to roll a position for each of the three scenarios and see what the likely results might be.

Scenario #1

The stock price has risen to above our January 2014 long call strike price of $115 per share. In this instance we would have the opportunity to buy back our in-the-money call position before it expires. Let's assume that the price has risen to $118 and we still have less than a month left before expiration. We could buy back the call for approximately $3 ($118-$115) and sell a new call that expires in January 2015. The January 2015 call will need to have a higher strike price and may or may not sell at a premium as high as the one we are buying back. Let's assume that we sell a new January 2015 call with a strike price of $130 for a premium of $2 (it will probably be higher, but let's be conservative). The combination of these two transactions nets us a loss of $1. But remember that we get to keep the premiums on the original two options we sold and that the put option will expire worthless, so we still have a profit. Plus we now need to sell another put option to expire in January 2015. If we raise the strike price for this put to $100 the premium will probably be in the range of about $8 or more. So, now we have just taken out another $7 ($8 from sale of put less the net loss of $1 from rolling the call) out of the original invested capital and still own the stock. We are also collecting the dividends from the 100 shares we own. If you recall from the first article, we had extracted $24.20 per share out the first time to bring the amount invested down to $72.09. Now we are extracting another $7 and will have reduced that number down to about $65.09.

In reality, the premiums of the new options we sell will probably be higher so the actual reduction will likely be more. If the stock price spikes higher sooner, the premiums' time value portion will not have decayed by as much which may affect the net amounts above. But the time premium of the new options will also have more time value left in them and thus will also have higher premiums on them to be collected. In reality, we often roll the positions within the last three to six months when the price is near the call strike because it often gives us the premiums we are looking for in options that are a year or more to expiration.

Scenario #2

The price of the stock falls below the January 2014 put option strike price of $85 when we are close to expiration. As explained in the previous article, we can allow the option contract to be exercised and purchase additional shares. But we always also have the choice of rolling this position forward to a new expiration date further out, like January 2015. Let's say that it is the week before expiration in January 2014 and the stock price has dropped down to $80. If we want to roll the position instead of buying the stock at $85, we can buy back the put at a premium of about $5 ($85 - $80), the amount the put is in the money, because there will be little time value left in the premium. We can then sell a new January 2015 put option with a strike price of $70 for about $7 premium and net $2 on this portion of the position rolled. The January 2014 call option will expire worthless so we will need to sell another call for January 2015 expiration with a strike of $105 to collect a premium of approximately $6. We will have extracted an additional $8 from our original invested capital and be set for another year.

Scenario #3

The price of the stock remains between our two strike prices. We can either let both options expire worthless as detailed in the previous article or we can consider rolling the position early. Why would we roll the position early in this situation? Because if the stock price is near the middle of the range, both the put and the call options' premiums may drop in value enough to make rolling early advantageous. When it becomes very inexpensive to buy back the existing options contracts (i.e. both contract premiums fall below $1.00 each), the amount that we can still earn during the remaining period to expiration may become so small that it becomes not worth the wait. If all we can earn over the last three to six months is less than $1, while we could also choose to sell new options contracts for premiums that may total over $15 that expire in January 2015, why would we wait? In this case we simply choose new strike prices that provide upper and lower boundaries, as well as good premiums, and roll the position. Again, we are still collecting the dividends on the shares we continue to own.

As you can see from these alternatives, we expect to pull at least an additional five to ten percent of our original investment back out using options each year. Whether we wait for the options to expire or choose to roll the positions early depends upon the APR we can achieve from each respective decision. If we can improve our APR by rolling the position, we will usually do so. As the years pass, we can usually expect to have extracted enough from the sale of options to cover the additional cash required to secure the put by year three or four. All additional cash extracted from the strategy is available to be redeployed to increase the yield of your portfolio. By about year ten you should have extracted all of your original investment and you will then be playing with house money, so to speak.

The other factor that needs to be considered is whether or not we want to purchase additional shares by allowing the put to be exercised should that scenario be in play. As is always the case, each investor needs to weigh each decision against his/her own goals and portfolio objectives.

During your retirement years you may also continue to use this strategy to create additional income from your portfolio. Once again, we want to remind readers that it is only appropriate to use this strategy on the stock of companies you really want to own for the long term. While the premiums may be significantly higher on more volatile companies, the risk of loss also increases. We deem that additional risk to not be worth the potential increased gains. We remain conservative in our approach with a view to the long term accumulation of wealth as our goal.

In future articles based upon this strategy we plan to skip most of the basics and details for the sake of brevity for our regular readers. We will link back to this and the first article for greater depth of explanation for those who are joining the series later or for those who just need a refresher.

As always, we appreciate all comments from those who take the time to post them and will do our best to answer all questions to the best of our ability. We plan on writing future articles on companies that fit the profile for this strategy when we feel the time and price levels are right for such considerations. We hope you will follow K202 so you won't miss those opportunities as we report them. Thanks for reading!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.