Enhanced Income Strategy For Chevron - Update 3

Jul.31.12 | About: Chevron Corporation (CVX)

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By Mark Bern, CPA CFA

We have tried selling puts three times on Chevron (NYSE:CVX) with the first two contracts expiring worthless. Now, after three months we have already captured 80 percent of the potential gain on the third contract and it is time to take some profit. We only have two months left until the contract would expire, but over that time our return would be just 0.63 percent (or 3.75 percent APR). This does not fit our requirement of earning at least 8 percent annually, so we will buy back the outstanding put option contract to close the position and wait for another opportunity to sell another put for a better return.

For those who read my first article on CVX, you will recall that I believe that CVX is a well-managed, dominant company with exceptional upside potential. I like the long-term prospects for integrated oil, and CVX especially. My reasoning is explained in greater detail in the first article and within another focus article about CVX, "My Favorite Dividend Growth Stock in the Oil Patch."

In the first article, when I first recommended CVX on September26, 2011, the stock price stood at $91.49. The current price for CVX is $109.93 (as of 10:15 a.m. on Tuesday, July 31, 2012). 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 portfolio returns fare 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 September 26, 2011 we sold one CVX November put contract with a strike price of $85 for a premium of $3.35. The option expired worthless and we pocketed $326 (net of commissions) for a return of 3.5 percent on the $8,500 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 CVX at $85 a share which would give us a cost basis of $81.65 ($85 - $3.35). That would have been a discount of 11 percent. But the contract expired worthless, so all we got to keep was the premium of 3.5 percent over a holding period of less than two months.

Then, on November 30, 2011, we sold another put contract, this time with an expiration of March 16, 2012 and a strike price of $87.50 for a premium of $2.46 per share. We collected $237 (net of commissions) and held the position for under three months for a return of 2.3 percent. So, thus far we have collected a total of 5.8 percent on CVX without holding the stock. Had this option been exercised we would have been obligated to purchase 100 shares of the stock for $87.50 a share and a cost basis of $85.04 ($87.50 - $2.46). But, alas, the contract expired worthless once again so we made another attempt to reap the rewards of being paid while we waited yet again.

On April 24, 2012, we sold a put option on CVX with an expiration of September 21, 2012 and a strike price of $97.50 for a premium of $3.95. That would have provided approximately 3.96 percent over the five-month holding period, a little lower than what I prefer but still within a reasonable range for this stock. That equated to an annualized return of about 9.5%. If the contract had been exercised before expiration we would have been obligated to purchase 100 shares of CVX at $97.50 per share for a cost basis of $93.55 ($97.50 - $3.95).

Since we are closing the position early we do not keep all of the original potential gain. We end up with a gain of $316 net of commissions ($395 - $9 - $61 - $9) for a return of 3.2 percent in three months; an APR of 12.96 percent. And now we are free to sell another put option contract on CVX if the opportunity arises within the next two months. This is not exactly what one would call rolling a position since rolling involves simultaneously closing one position and opening a new one with a longer duration on the same day. This is more like taking what the market will give us and waiting patiently for another opportunity to do more of the same. So far we have collected a total of $879 (net of commissions) in premiums over the last ten months for a return of 9 percent on our money without buying any stock. This falls within our targeted goal of achieving at least an 8-10 percent annual return on our money while we wait patiently to buy our stocks at a discount. In most years, some of the stocks do better than our strategy and some of the stocks return less than our strategy. What we are trying to accomplish is a more consistent return that, over the long term, will beat the buy and hold strategy as well as beating a broad index like the S&P 500.

As is my custom I believe that is important that I 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 will 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 could not 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 is not 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 Investing for Income Strategy," for a primer. Links to all articles in this series can be found at a blog that I have set up here at Seeking Alpha at the link for the first article. Each article is listed in chronological order and the ticker(s) of the company or companies featured in each article is listed next to the link. I update the blog weekly.

Thanks for reading and I wish you all a successful investing future!

Disclosure: I am long CVX.