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By Mark Bern, CPA CFA

Now that we own Johnson Controls (JCI) after being put the stock when the price of the stock remained below the July 2012 put strike price of $29 on the put we sold in April, we need to employ a strategy using options to enhance the income from our new holding. If you have been following the series, you will recall that we sold a put option on JCI in our October 6, 2011 article and again in December and once again in April. The first two puts we sold expired worthless and we kept the premiums of $332 (net of commission) after five months for a return of 11.1 percent. We sold another put on JCI on April 24, 2012 in our last update article on JCI which also included a discussion of Chevron (CVX), another of our favorite companies.

This time we sold a JCI July 2012 expiration put with a strike price of $29 for a premium of $105 ($96 net of commission) and we were put 100 shares at $29. We now own JCI with a cost basis of $27.95 (for tax purposes; $29 - $1.05). Now we'd like to get some of that original investment back and we are going to do that by using another, relatively low-risk options strategy, called the strangle. The 52-week high and low for JCI is $36.86 and $23.37, respectively. We would like to own more JCI for the long term if we could get the stock at $20 a share or lower and we don't mind selling the stock for a profit if it goes up to make a new high. In the meantime we'd like to take some of our money back out of the stock to increase our overall return. And that is just we are going to do.

Here is how we set up the position. We already own the stock with a cost basis of $27.95 and the current price is $24.31 (all quotes for this transaction are after the market close on Wednesday August 1, 2012). We sell a covered call expiring in January 2014 with a strike price of $30.00 (above our cost basis) for a premium of $1.65. We also sell a put option expiring in January 2014 with a strike of $20 (below the 52-week low) for a premium of $2.65. We will need to keep $2,000 of our extra cash available in the account to secure this put and this amount will be included in calculating the return. We have now received $412 (net of commission) in new premiums.

We have three likely outcomes:

  1. The stock price will go up above the covered call strike price.
  2. The stock price will go down below the secured put strike price.
  3. The stock price will remain somewhere between the two strike prices.

If scenario one occurs we will have a gain of 15.1 percent on the total amount committed to the position of $4,795 ($2,795 + $2,000). Here is how it breaks out:

  • Premiums collected (after commission) $412
  • Gain on stock $205
  • Dividend collected $108

Total $725

If the second scenario occurs we will be obligated to purchase another 100 shares of JCI and will have brought our total investment per share down to $23.98 ($20 + $27.95)/2. But we also have other cash flows involved. We have an unrealized loss of the stock of $795 (assuming it drops down to the $20 strike price of the put), and offsetting this we still have the premiums of $412 and the dividends of $108. This brings the total loss down to $275, or about -5.7 percent. If the stock price drops to the $20 strike price of our put option it represents a 17.7 percent fall from the current price of $24.31 but only a 5.7 percent loss from our cost basis. We only lose 5.7 percent instead of 17.7 percent. Of course, if the price falls further, we will lose more, but when the stock price rebounds we will also profit more because of our lower cost basis.

If the third scenario occurs we will have collected the premiums of $412 and the dividends of $108 for a total return of 10.8 percent. Remember, we make money even if the price goes nowhere and our losses don't become significant until the stock price falls more than 15 percent. This is one of the key elements of the strategy; reducing risk of loss.

If the price goes up we win. If the price goes nowhere, we win. If the price drops, we are better off than just holding the stock and collecting dividends. Plus we always have another choice that we can employ in either of the scenarios: we can roll the position and systematically take more of our original investment out while retaining ownership of the stock and collecting the dividends.

Here is an example of how that would work. In the case of scenario one where the stock goes up to or above the call strike price, we simply roll the call option out into either a more distant expiration or to a higher strike. Let us assume that the price goes to $32 close to the expiration date and we decide to roll the position because we do not want to have the stock called away. We will have to pay very close to $2.00 premium ($32 - $30 call strike) to buy back the call option we sold originally in order to close out the position. At this point the put will be expiring worthless so we still keep that premium and after we have closed the call position we initiate another strangle with an expiration date in January 2015. We will move both the put and call option strike prices up to maybe $27 and $37, respectively and collect the new premiums. The new premiums should be a little less than what we collected on the original positions because there will be about six months less time built into the premiums. So, we will assume that we can collect closer to $3.50 for the two options. So, we keep the stock, continue to collect the dividends and we collect another $1.50 ($3.50 - $2.00 cost to buy back the call) in option premiums. So, now we have collected a total of $585 in premiums to reduce the cost of our stock from $27.95 to $22.10 ($27.95 - $5.85). Or, at least, that is one way to look at it. Another way to look at it is that we have collected an extra 10.2 percent on the maximum funds needed to make the transaction ($2,795 + $2,700 = $5,495), plus the dividends and any appreciation in the stock price. The appreciation and dividends would amount to an additional $513, or 9.3 percent. Add that to the 10.2 to get a total return of 19.5 percent and it begins to get interesting.

If the stock price drops and we decide we really don't want to buy another 100 shares, we can roll the position and take some more of our original investment out by closing out the position (buying back the put and allowing the call to expire worthless) and then selling another set of short put and call at lower strike prices with expirations in 2015. Our preference is to buy the additional shares since we already like them at the current level and will like owning more at the lower level. I love buying things on sale. Don't you? But again, if we roll the position out, we will extract about the same additional premiums that we did when we rolled the position in the earlier example. Let us say that the price goes down to $18.50 and makes a new 52-week low. Now we will buy back the put for about $1.50 per share ($20 strike - $18.50) and the call will expire worthless. We will sell a new set of put and call options with strikes around $15 and $23, respectively. Our average cost, taking into consideration all premiums collected from the earlier positions and the net new premiums we will collect from selling the new options will be near $20, so even if the stock gets called away we make something. But we always hope that the options expire worthless so we can sell some more and keep collecting more premiums and dividends.

If the price were to go much lower than $20, we would most likely wait for the stock to rebound some before employing new positions. We prefer to not lock ourselves into a potential loss if the stock is called away unless the fundamentals of the company deteriorate substantially and we decide we no longer want to own the stock. Then we start selling calls closer to the current price with shorter expiration hoping to have the stock called away. In a market crash situation, we tend to average down using this strategy, collecting premiums all the way down and continually lowering our average cost per share. When the market rebounds, as it always has in the past and most likely will in the future, we tend to stick with selling puts on the way back up until the stock regains most of it prior value.

I believe that I must 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 ten 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 ten 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 ten percent above the stock price at the time the option is sold; therefore you should be selling at no less than ten 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, we enjoy the comments and will try our 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 the series for a primer. You can find a link to it and all the other articles from this series at this link: My Long-Term, Enhanced Investing-for-Income Strategy blog. The articles are listed chronologically with the ticker symbol for the stocks covered.

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

Source: Long-Term, Enhanced Investing-For-Income Strategy For Johnson Controls