By Mark Bern, CPA CFA
We've tried selling puts only twice on Medtronic (MDT). The first contract expired worthless, but we did collect the premiums on the put we sold. This time we have decided to buy back the put contract to close the position early. In other words, we are taking profits because what little premium is left is not worth the wait. At the market close on Friday, July 27, 2012, the premium on the August MDT $36 strike put that we sold in April is only $0.06 per share. Thus far we have made a profit of $252 (net of commissions) for a return of 7 percent in less than ten months or an APR of 8.4 percent. 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. I will start by reviewing the results of what we have done thus far with this excellent company's stock.
For those who read my first article on MDT in this series, you will recall that I believe that MDT is a well-managed company with exceptional long-term potential. For those readers who missed that first article it contains my reasoning explained in greater detail.
In the first article, when I recommended MDT on October 7, 2011, the stock price stood at $32.83. The April 26th closing price was $37.10. 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 it 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 October 7, 2011 we sold one January 2012 put contract with a strike price of $30 for a premium of $1.45. The option expired worthless and we pocketed $136 (net of commissions) for a return of 4.5 percent on the $3,000 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 MDT at $30 a share which would have given us a cost basis of $28.65 ($30 - $1.45). That would have been a discount of 12.8 percent. But the contract expired worthless, so all we got to keep was the premium of 4.5 percent over a holding period of a little over three months.
On April 26, 2012 we sold a put option contract on MDT with an expiration date of August 17, 2012 with a strike price of $36 for a premium of $1.40 a share. Our return, if the contract had expired worthless, would have been 3.6 percent over a holding period of four months. We decided to buy back the put option contract to close the position with a remaining premium of just $0.06 per share. We netted $116 after commissions ($140 - $9 - $6 - $9), for a return of 3.2 percent over three months. This brings out total return on MDT to approximately 7.7 percent over ten months, for an APR of 9.2 percent.
We now have the opportunity to sell another put option on MDT again when a good opportunity arises. But patience is probably the most important aspect of this strategy and we must wait for the stock price to decline a bit before we act again.
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 this series, "My Long-Term, Enhanced Income Investing Strategy," for a primer.
Thanks for reading and I wish you all a successful investing future!
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.