By Mark Bern, CPA CFA
We didn't get put the stock on the first try, but we did collect the premium on the put we sold. Recall from my first article on Colgate-Palmolive (NYSE:CL) that the stock price was $89.54 (all prices and premiums quoted from the first article are as of the market close on September 29, 2011) while the premium on the November $82.50 strike Put was $2.19. We collected $219 ($2.19 x 100) on the one contract that we sold, but we also paid a commission of $9 (assumed amount that is about the average of discount brokerage premiums; you can do better if you shop around).
That leaves us will $210 net of commissions which represents a return of 2.55 percent for 54 days (expiration occurred on November 18). If you annualized that return (using the method I explained in my original article in this series; link provided at the end of this article) you would come up with about 12.7 percent without owning any stock. That is the kind of return that makes this strategy work. We won't get those every time, but often enough to keep me happy.
Our next step was to sell the January 2013 $80 strike with a premium of $4.95. We made this transaction in December 2011 and after seven months we have achieved 83 percent of the total potential gain with nearly six month left of the contract. So, it becomes advantageous to take profits by buying back the put to close the position and wait for another good opportunity to sell another put that will offer a better return.
After closing the position and paying the remaining premium of $0.68 per share (or $68) we are left with $409 net of commissions ($495 - $9 - $ 68 - $9). This gives us a return of 5.1 percent in seven months. If we add this to the return from the original transaction we end up with a return of 7.65 percent in ten months, or an APR of 9.2 percent. And now we have the freedom to use the cash to sell more puts if the opportunity arises to do so before January 2013.
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 is please see the first article in the series, "My Long-Term, Enhanced Investing For Income 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.