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Brian Abbott
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In investing, I have a heavy focus on reinsurance companies, and I enjoy learning how to value their investment portfolio and underwriting ability, taking inspiration from the reinsurance companies that Warren Buffett used to help build Berkshire Hathaway's investing empire. The other focused... More
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Montana Semi-Precious Metals
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  • AMZN CFO Resigns.... In 2015

    OK, so it's not until 2015. Somehow I missed news this during the trading week:

    "On September 3rd, the company announced that its Chief Financial Officer, Thomas J. Szkutak, will retire in June of 2015. Szkutak has held this position since October 2002 and will be succeeded by Brian Olsavsky, the current vice president of finance for Amazon's global consumer business."

    Ordinarily I would say that CFO departures are among the most ominous, but seeing that Mr. Szkutak has been in place for 13 years it's hard to say this is an automatic negative. However, given the stock price performance after earnings releases over the reported losses the past few quarters, perhaps there was some mounting pressure and the job was getting more uncomfortable. In other companies, CFO resignations have resulted from disagreements over how things get accounted for in ways that can impact near-term earnings.

    So for now, I will say this is probably a non-event especially since it is a pre-announcement for 2015, but one that deserves monitoring especially with the next earnings release.


    Tags: AMZN
    Sep 06 12:22 PM | Link | Comment!
  • Selling Puts On The Dogs Of The Dow


    I have previously written about selling puts on certain sectors such as reinsurance industry and offshore oil drilling. I wanted to expand that to another area I have been working on for a few years: selling puts on out of favor members of the Dow Jones Industrial index. There are several strategies for identifying these out of favor stocks, and perhaps the most widely familiar is know as "Dogs of the Dow" strategy. The strategy has been reviewed elsewhere, but in summary it involves purchasing the four or five Dow stocks with the lowest share price, out of the ten highest yielding Dow stocks.

    This conveniently narrows the universe of stocks from 30 industrial stocks down to a handful. For a personal investor with limited free time but a desire to self-manage their investments, that has a lot of appeal to me. That's ok with me, I was really interested in using it as a stock screening tool.

    Fundamental Analysis

    The rationale behind the Dogs of the Dow strategy is that different stocks and sometimes entire sectors become out of favor and lag the market. One way of identifying this is by comparing yield among stocks. Capital finance theory, and decades of market history, indicate that companies are reluctant to lower their dividends and thus dividend yield tends to be a fairly consistent number in the short term. Thus, the Dogs of the Dow strategy uses dividend yield as the first screen. I believe this gives the strategy some added appeal for yield-oriented investors. Furthermore, the focus on dividend yield also helps dampen the market moves of the stocks since they contain this income stream and are often held for decades by long-term term yield-oriented investors.

    Another part of the rationale behind Dogs of the Dow is that only the largest companies achieve the size and scale necessary to be added to the Dow Jones Industrial index, and while the industries are cyclical and companies will run into periodic difficulties, it is felt unlikely that they would actually go out of business. There are some noteworthy near-failures such as Kodak and AIG - proof the ANY strategy with stocks will have risk. Thus the importance of diversifying this risk by holding multiple companies, and using careful analysis, and in my case - purchasing at a further discount by selling out of the money put options, as discussed below.

    Buying the Dogs of the Dow at a Discount

    What I have been doing is taking the DOD a step further and selling out-of-the-money (OTM) puts on these stocks, rather outright purchasing of the stocks. I am using a cash-reserved put strategy, meaning I have the money set aside in short term bonds to purchase the stocks, should that become necessary. In most cases this would require a 5 to 15% drop in share price. For me, that gives me a safety margin in knowing that I wouldn't be purchasing the stocks unless a modest drop first occurred. In other words, I can buy the same stocks at a potential discount. Oh yes, and there is the put premium too - I get that no matter what. Keep in mind that the stock prices won't always drop and this means sometimes you'll be left out of the stock position. Note that it is hard to backtest a strategy like this, because of the multitude of different expirations and strike prices one could select, and also the lack of readily available historical option prices.

    The strategy is rotational in nature, meaning that if you perform this every 6 - 12 months with the current Dogs of the Dow, eventually markets will change and different stocks will languish at different times. Over time, this helps diversify the portfolio. In essence, the Dogs of the Dow is the selection strategy, and selling the out of the money put is the entry strategy.

    A strategy wouldn't be complete without an exit strategy, and for this I like to sell covered calls one or two strike prices out of the money on any stock positions that I acquire through exercise. This is summarized below.

    Managing the positions

    There are three choices available once a position is initiated by selling a put option:

    1. Buy back the option (buy to cover). I typically do this when the underlying has a rapid move upward early in the life of the put contract, resulting in a rapid gain of 50%. I often will close those out at a profit to free up capital. Otherwise, you tie up the margin for a lot more time just to get the other half of the gain - and of course it can still turn into a loss.

    2. Let option expire worthless (out of the money). This is the sweet spot. This frees up margin capital and results in the maximum profit potential for the position.

    3. Let option exercise (in the money) - this is the part of the strategy that can keep you awake at night; make no mistake, this is where the losses can and do happen. This is not a necessarily a bad outcome, since the positions were chosen by company valuation as being desirable investments. And I generally only sell out-of-the-money puts, which implies the stock would have fallen further - presumably making it a better valuation as long as the fundamentals of the company hadn't changed. I typically will turn around and sell covered calls on this new long stock position.


    The current 10 Dogs of the Dow as of July 7, 2013 are Merck (NYSE:MRK), AT&T (NYSE:T), Pfizer (NYSE:PFE), Intel Corp (NASDAQ:INTC), General Electric (NYSE:GE), Chevron (CHV), McDonald's (NYSE:MCD), Procter & Gamble (NYSE:PG), DuPont (NYSE:DD), and Verizon (NYSE:VZ). The first five companies are known as "small dogs", because they have the lowest 5 share prices of the top ten highest-yielding Dow Jones Industrial stocks.

    For illustration purposes, let's say I am most interested in establishing a position in Merck . The current share price of MRK is $47.16. I would consider looking at selling puts at the $40 strike price at the longest duration possible which is currently January 2015. The bid/ask spread (while market is currently closed for the weekend) is $2.93-2.98. One could get more money for higher strikes, such as $3.65 for the Jan 2015 $42.50, and $4.95 for the $45 put. These are summarized below.

    MRK Strike PricePut Bid price

    Table 1. Example bid prices for MRK January 2015 put options.

    I often normalize examples for a dollars-at-risk amount of approximately US$10,000. For this example, that would constitute selling approximately 3 contracts of MRK January 2015 $40 puts. Taking the worst case of $2.93 per contract, that would result in premium of $879 for being willing to purchase 300 shares of MRK at $40. Total purchase price would be 40.00 x300 = $12,000 minus the $879 put premium. Not bad considering that would be a discount (avoided loss) of $2148 from what the current purchase price would be at $47.19. I say "avoided loss" because in the scenario in which the puts would have been exercised would be if the share price were below $40.00. The buy-and-holder purchasing at $47.19 would have suffered the loss down to $40.00 and beyond, while the cash-secured put seller does not lose in real terms until the share price is below the strike price (minus the put premium).

    Note that I selected a conservative example by going several strike prices below the current $47.19 MRK share price. One could earn more put premium, while also having more dollars at risk of loss, by selecting higher strike prices. Also, January 2015 is still a year and a half away, and one could earn lower put premiums more quickly by selecting earlier expiration dates. My rationale for generally selecting the longest dated expiration is that it produces the highest premiums (although with the slowest decay characteristics) and helps engrain the long-term nature of things like mean reversion that the Dogs of the Dow is based upon. Around September the 2016 options should become available and one could earn higher amounts by selecting longer dated expirations. Lots of choices!


    To summarize, what I like are the following points about this Dogs of the Dow / Put-Selling strategy:

    1. Generates current income through put premium
    2. Helps acquire stock at a discount to the current price, by selling out-of-the-money puts
    3. Utilizes a value / mean-reversion strategy to objectivize the stock selection process.
    4. Adding a covered call selling strategy on any acquired long stock positions builds in an exit strategy to help turnover the portfolio over time and harvest gains.
    5. THe Dogs of the Dow method also focuses on large, dividend-paying industrial stocks which has added appeal for yield-oriented investors.

    Disclosure: I am long PFE, T, GE, INTC.

    Tags: MRK, PFE, T, GE, INTC
    Jul 08 11:52 AM | Link | 2 Comments
  • Selling Puts On Offshore Drilling Companies

    As a follow-up to my recent article on investing in offshore drilling companies, I next wanted to outline a strategy of writing put options on selected companies in this sector. I have also previously written on the mechanics underlying the put-selling process, so I will not review that in much depth here. The rationale for offshore drilling companies is that I invest heavily in this sector as a proxy for exposure to the oil market, and their higher than average volatility seems to make them a rich target on which to sell options.

    Guidelines for Put-Selling

    For simplicity, I made some rules so I could show one representative strike price of each stock. (Note that these guidelines are around the selection of expirations and strike prices, and assume that the investor has already worked through the stock selection process first, and is simply choosing among underlying stocks that he or she would like to own.)

    • Selected the next lowest $5 or $10-unit strike price, targeting a 5-10% out-of-the-money strike price
    • Sold one contract each
    • Assume a $10 commission
    • Selected an expiration close to September 2013 (mainly based on Atwood's lack of LEAP options)
    • Assumes an order execution at 10 cents above the current bid on the put contract. (A price that will nearly always get executed, even if it sacrifices a potentially lower price to the put seller).
    • Trade date of February 5, 2013.

    Current year 5-10% OTM puts for offshore drillers

      strikecurrent priceput contract pricemax. long exposureexp.CAGR if unexercised
    ENSCO plc(NYSE:ESV)60$64$3.80$6,0009/20/20139.92%
    Diamond Offshore(NYSE:DO)70$76$2.70$7,0009/20/20135.97%
    Noble Corp(NYSE:NE)35$41$1.70$3,5009/20/20137.35%
    Atwood Oceanics(NYSE:ATW)50$54$2.85$5,0009/20/20138.84%

    Calculating Returns using CAGR: "Return on Strike Price"

    In my analysis, the compound annual growth rate is calculated as a return based on premium divided by total put exercise price, and annualized from the date of selling the put through date of expiration. It assumes that the put is held until expiration, and it actually doesn't matter whether the put expires in or out of the money (that difference merely affects whether you purchase the stock or not - the put is gone at that point, etiher way). If you look at the expanded table, you will see that under these put selling criteria, the CAGR ranges from 6 to 11%.

    I have seen some option writers express the "return on margin", in which a similar calculation is used except dividing the put premium by the initial margin. The problem I have with that approach is that the margin requirement changes with time, whereas the strike price remains constant. Also, the return on margin will typically be several times higher than my return on strike. I think a focus on return on margin indicates a mindset of someone attempting to go fully leveraged, and that can be disastrous with this kind of strategy once an equity downturn inevitably hits.

    The most conservative investors will stick to cash-reserved puts, in which case the CAGR that I list under my calculation more truly reflects a return on the full money at risk (i.e., the full cost of the stock at the strike price). At 6 to 11%, that's not a bad return, and in the worst case scenario it gets you in to your target stocks at prices 10% lower than what the initial stock price had been. I am somewhere in between and will use 25-50% of the available margin, which helps avoid margin calls during times that we get 5 to 10% corrections, which are always going to happen. It also helps boost my effective return beyond the indicated CAGR, but make no mistake, there is additional risk being taken in order to achieve that higher return. It is leverage and it can wipe you out if not managed well.

    Hold until expiration or exercise

    I have used this method for 8 years now. It is fairly rare for me to get exercised on the put options with this method, and the times it does happen, the stock will usually go up later and make a net profit for me. As I have written before, this has become the exclusive way that I acquire shares, and I dispose of them later via covered calls at higher strike prices that usually end up getting exercised eventually. The returns listed above under CAGR assume holding until expiration. Even if the contract is exercised, making you the (hopefully) proud buyer of stock, you still earned the CAGR.


    No discussion about investing would be complete without a discussion of risks and what can go wrong. Probably the biggest negative headline to happen in the offshore drilling space is the BP Macondo well disaster in 2010. Not only was the environmental damage disturbing and the loss of human loss horrifying, but the business of offshore drilling was hurt as well, with a moratorium on new drilling permits in the US Gulf of Mexico waters.

    An additional risk with writing naked (uncovered) put options on a margined basis, rather than cash-secured basis, is that the additional leverage can amplify your losses in a severe market downturn. Some wise investors have compared writing puts on margin to "picking up nickels in front of a steam roller." This means you might make a lot of small profits, but one big correction could come along and wipe out your gains, and then some.

    Real-world example

    As I have noted on several occasions, selling out of the money puts is the only way in which I acquire stocks (via occasional exercise), and selling calls is the only way I dispose of those stocks (again, via occasional exercise). In fact, it works so well that a big run-up like we've had the past month leaves me with a smaller equity position, due to positions being called away! Yes, that means my upside got limited, but keep in mind that in order to sell that stock it meant I sold an out of the money put, the stock dropped and I bought it on exercise, then sold an out of the money call (usually at a strike price higher than the put strike had been) and the stock went up and I then sold it. Plus I used leverage so did this on margin with a larger number of positions than I could have purchased on a cash basis.

    My best example is Noble Corp . I have a position in NE right now that is about 5% of my total portfolio but represents my single largest stock position. I have acquired it in tranches over the past 4 years exclusively via selling OTM puts. The fact that I got exercised indicates that the stock did go down periodically. However, there have been many more puts that actually never got exercised and expired worthless - so my stock position doesn't even tell the whole story, in terms of profits. NE has always rebounded and is nearing a recent high. The whole position is now at about a 15% unrealized long term capital gain. (The fact that my cap gain is all long-term quickly tells me that my last put exercise on NE was over a year ago, by the way). I just had a big re-write of LEAP calls on the entire position, since all the covered calls just expired a few weeks ago in January 2013. Plus, it pays some dividends which I continue to collect along the way. The recent performance of NE allowed me to take the covered call strike price up a notch, which will increase my profits further if they get exercised. Because of the relative size of this position I have scaled back the puts I write against NE since I don't want to acquire too much more. However, once I sell some NE stock through covered call exercise, I will put that freed-up capital to work by selling more NE puts (at lower strike prices - meaning I will potentially get back in at a lower price than I had sold the profitable position on through covered call exercise).


    This analysis has shown a way of selecting put contracts to write, and has used offshore drilling companies as an example of a target sector. The CAGR for the methodology I outlined is around 6-11%. The example I gave with Noble shows how the cycle of selling puts and calls can be repeated, and offers the chance to squeeze more alpha out of a stock you want to own, rather than passively just letting it sit there in your portfolio.

    Thanks for reading and sharing your comments!

    Disclosure: I am long NE, DO, ESV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

    Tags: ATW, DO, ESV, RIG, SDRL, NE, options
    Feb 04 8:23 AM | Link | Comment!
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