I had written this article describing the qualities of McDonald's (NYSE:MCD) a while back. It contains an evaluation of McDonald's and it turns out that McDonald's is a stock with strong growth and fundamentals, a desirable chart and a strong balance sheet. Although it has many qualities, McDonald's has declined considerably from its high and is now close to its 52-week low. We never know if it will drop further. Therefore, I will describe a safe way of entering the position through this article.
But first, here is a daily chart of McDonald's:
Through the chart, it seems like McDonald's has reached a strong short-term support which it tested three times in just the past half a year. It also is oversold (RSI: 30.9), and looks very much like it's due for a rebound, but like life, the stock market is very much unpredictable and it might be better to have some sort of insurance as we enter the position. Here is one method I recommend:
This strategy, by far, is my favorite strategy of accumulating shares. In the table below, I show a few put options that I am considering to sell.
|Strike Price||Expiry||Premium||Effective Entry Price|
The Dec. 2012 and Jan. 2013 options are for investors who want to get into the position sooner; the Mar. 2013 and Jan. 2014 options are for investors who can and want to wait long term.
Below, I will use the $82.50 Mar 2013 option as an example of how the trade can be profitable for any direction the stock goes. I personally prefer the March 2013 put as its time frame, to me, is just right - about 4-5 months is about how long I am willing to wait. Its Implied Volatility (IV) is also higher than the Dec 2012 and Jan 2013 puts, at 19.60. Although this number is still low, one could either wait for a better IV, which could be achieved before earnings or just make do with the lower-than-usual premiums now.
Scenario 1: Stock stays between $82.50 and $87.46 (today's price) at expiry
In this scenario, the option will expire worthless and one will get to keep the premium. Following this, one can either sell another option or use this cash to buy the shares immediately - the premium received would lower the average price of the shares bought.
Scenario 2: Stock rises above $87.46 (today's price) at expiry
In this scenario, the option will expire worthless and one will get to keep the premium. This scenario might not be favorable to one as the average price of the shares bought, even after being lowered by the premium, would still be higher than the market price today.
Two ways to solve this problem is:
1. Have shares in McDonald's beforehand. The profit gained from the shares rising would offset the higher average price of the shares paid.
2. Roll out to another expiry to gain even more premium before buying the shares.
Scenario 3: Stock drops below $82.50 at expiry
In this scenario, one would be obliged to buy 100 McDonald's shares at $82.50 each. But, after counting the premium in, the effective buying price decreases to $80.46 per share. Like scenario 2, this might not be favorable to an investor if McDonald's price falls below $80.46. But, I think that this is highly unlikely, as McDonald's is a company with a steady flow of earnings and that will cushion the plunge. Even if it drops below $80.46, I would view it as a pleasant surprise and buy more shares.
The put selling option strategy is one that is good in a number of ways:
1. It can effectively lower one's entry price
2. It provides a good cushion for one, one can cut his loss considerably (if the stock plunges). On the other hand, one can also increase his gain considerably (if stock jumps).
3. One does not need to monitor his position too often.
These are just some merits of the put-selling strategy. I like to use this method on stocks that have good fundamentals but have dropped considerably from their high. Even so, please do your due diligence before trading.
All prices shown in this article are prices based on the closing on Monday, 5th November 2012.