Regular put selling, with a twist, is our favorite strategy for stocks we think are going to do well in the mid to long term; stocks which would also make good covered call trades.
International Business Machines (IBM) is one such great covered call candidate; but we are going to use a hedged put sale instead.
Before going through this more complex trade, let's look at why IBM is a good covered call contender. That is buying stock and selling calls at or out of the money against it.
Covered calls work best for slow moving, 'boring' stocks, that over time will do well. The 'doing well' bit is important, as ultimately we own the stock and want it to move up. But not too quickly. Large spikes mean the sold options may move in the money and our stock be called away. We can buy it back, but at a higher price.
IBM, however, is perfect. It has had a steady run up in recent years:
It is backed by a strong and rising dividend - a key element for investor support in recent times. This in turn is backed by strong cashflow. And a stock buyback program.
It is also one of the companies that will do well from one of the key IT transformations taking place at the moment: cloud services. IBM is a key enabler of the cloud - the outsourcing of computing power to third party providers and/or the internet - through its hardware products and, critically, its professional services. It was IBM's former CEO, Lou Gerstner, who recognized that services would be a great money spinner in a time of change. And with many CIOs considering a move of some of their internal IT infrastructure into the cloud, who better to help them than IBM?
Anyway, strong stock support from dividends, good cashflow, stock buybacks and a rosy future in a growing industry, but without the flashy allure of some of their sister tech companies, makes this the perfect long term covered call candidate.
And so why not do a covered call?
Mainly because of the cash cost of doing so. IBM is approximately $200 and hence requires $10,000 just to do one 100 stock + contract on margin.
Also, covered calls are actually riskier than they look. To see why, consider their synthetic cousin: the naked put. The sale of a put is exactly the same - it has the same risk graph - as a covered call.
This might surprise those of you who would never consider selling naked options, but would count covered call investing as one of the more conservative options strategies. But they are the same; a downturn in the stock affects both strategies equally badly.
We can solve the first issue, the high cash cost, by selling puts instead of doing a covered call; and mitigate the second, the risk of a naked position, by hedging the trade with a bought out of the money put. The margin on such a trade is much lower than a stock purchase; hence the ROI on cash outlay can be much higher.
Let's look at the specific trade with IBM at $194.85.
- Buy 5 Apr13 180 puts @ $8.38
- Sell 5 Sep12 195 puts @ $2.94
- Cost: $2,720
- Margin: $7,500
- Total cash outlay: $10,220
The plan is to sell ATM puts every month until April 2013 (eight months).
Should any of these monthly puts expire in the money we will roll to the next month at the same strike. Otherwise we sell the put nearest ATM. For example if the stock is $193 at the expiry of our Sep12 195 put we would buy it back and sell a Oct12 195 put. If, however, the stock is at 201 at the expiry of our Sep12 195 put we would sell a Oct12 200 put.
Our 'bet' is that 8 months of time decay collected from the put sales (or rolls) is greater than the purchase of the hedge (plus any intrinsic value of the puts we are short in April).
In the worst case scenario - where the stock falls steadily to $180 (or below) in April - we will lose the cost of the hedged put ($2,720) and the cost of buying back the short put. This is unlikely. However, we need to follow our main risk management guideline: never risk more than 2% of capital in any trade.
We will therefore have a stop loss: should we have a cumulative net (ie including any premium received) unrealized loss of $2,000 at any stage in the next 6 months we will take off the trade.
In the meantime we can take comfort from the old saying that a manager can't be sacked for buying IBM. Let's hope the equivalent is true for the trader doing regular hedged put sales.