By Mark Bern, CPA CFA
We have tried selling puts four times before on VF Corporation (VFC) and in three of the four cases the contracts expired worthless, but in the remaining instance we bought back the contract early for a premium of only $0.15 with about one month to expiration. We rolled the position forward to collect a better premium over the next few months. The new contract expired last Friday just out of the money giving us an opportunity to sell another cash-secured put to collect some more premium income.
For those who read my previous article in the series on VFC, you will find a summary of our previous trades and recall that I believe that, while the company seems fairly valued at the present, it is well-managed and has exceptional long-term potential. My reasoning is explained in greater detail in my first article about VFC (the first article can be found through a link within the previous article link above). If you are interested in a focused analysis of VFC you can find that in an article I wrote in late December regarding my expectations for the company and future dividends.
On April 27, 2012 I recommended selling our fourth put option contract on VFC in less than a year; this time the put expired on August 17, 2012 with a strike price of $150 and we collected a premium of $6.70 a share. Our return was 4.4 percent over a holding period of about four months. That brought our total return on our cash position to about 13.8 percent over the first eleven months. That falls nicely above the parameters of our goals for the strategy.
Today I want to recommend selling a put option contract that expires on February 15, 2013 with a strike price of $140 and collect a premium of $7.50 per share (prices are quoted at the end of trading on Monday, August 20, 2012), which works out to about $741 after paying a commission. If the option expires worthless our return will be 5.3 percent over a holding period of about six months, or an annualized return of about 10.6 percent. If the price falls below the strike price on the expiration date, or if the option is exercised prior to expiration, we are obligated to purchase 100 shares of VFC for $140 for a cost basis of $132.50 ($140 - $7.50), which works out to about an 11.5 percent discount from the current price of $149.73. Since I believe the price to be fairly valued at current levels I should very much appreciate the opportunity to make the purchase at $132.50.
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 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-ten 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 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 ten 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 may not be 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 the series for a primer as well as all other articles published in this series at "My Long-Term, Enhanced Investing-For-Income Strategy Concentrator."
Thanks for reading and I wish you all a successful investing future!