By Mark Bern, CPA CFA
We have sold three individual BlackRock (NYSE:BLK) puts on three different occasions: October 2011, January 2012 and April 2012. The first two puts expired worthless and we kept the premiums totaling $1,072 (net of commissions). The third put was exercised at expiration in June and we were obligated to purchase 100 shares of BLK at $180 but ended up with a cost basis of $175.40 ($180 - $4.60 from the April put premiums). Tuesday the closing price for BLK is $174.01 which means we have an unrealized loss of $139.
For those who read my previous article on BLK, you will recall that I continue to believe that BLK is a well-managed, dominant company with exceptional upside potential. I like the long-term prospects for BLK and consider it a good long-term holding. My reasoning is explained in greater detail in the first article (you can link to the earlier article from within the article linked above).
If we had purchased the shares outright on April 24, 2012, when we sold the last put option contract, the closing price was $188.57. Thus, we achieved a discount from that price of seven percent by selling the put. By not purchasing the stock when we sold the first put in October 2011, we have missed $437.50 in dividend payments, but instead we collected the premiums of $1,072. The share price has appreciated since October by $2,324. So far, we are behind the buy-and-hold position on this stock by $1,828.50. Full disclosure has been made. But now we need to begin selling puts from here to increase the yield from the stock we hold. Remember, it isn't how we do on any one individual stock that counts, it is how the portfolio as a whole performs over time. But, admittedly, this position will offset others that do better.
Today I want to sell a call option on BLK with an expiration of January 18, 2013, and a strike price of $185 for a premium of $5.60. That will provide approximately 3.1 percent over the next five months. If the contract is exercised before expiration, we will be obligated to sell our 100 shares of BLK at $185 per share for a gain of $15.20 per share from our cost basis of $175.40 ($185 +$5.60 - $175.40). We rarely get as much premium for selling calls as we do for selling puts. This is an exercise in trying to enhance the yield. If we can achieve another five percent in premiums captured by next October, we will have made up much of what we missed relative to the buy-and-hold position. If the stock languishes and the shares are not called away by January, I believe we should have a good shot at that additional five percent. If the shares are called away, we'll just sell another put option and take another swing.
But notice that while the stock rose and fell, we weren't riding the roller coaster. The peace of mind of earning money on cash secured puts kept our account rising without the rocky ride. There may be something to be said for that. Then again, others may have preferred the ride all the way up to near $210 per share and then back down again to $160.25. But of course, we are now on the ride, so let's make the best of it and try to enhance our yield.
As is my custom, I believe that it 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) corrects 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 "My Long-Term, Enhanced Investing-for-Income Concentrator" where you can find the first article in the series that explains the strategy in detail along with all of the other articles in the series listed chronologically by company ticker symbol. 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.