Buy Stocks On Sale Using This Strategy

Includes: EEM, EFA, IVV, IWM, SPY
by: The Financial Lexicon

Since November 16, 2012, the major U.S. equity indices have been on a tear. The relentless move higher likely left plenty of investors waiting for a decent sized pullback that never came. And now, many are surely thinking, "I don't want to buy now only to watch the market go down. But I also don't want to not buy now only to watch the market go higher."

This rally has been so persistent that not even broad-market earnings declines have been able to stop it. In case you are unaware, after 11 straight quarters of increases, S&P 500 (NYSEARCA:SPY) trailing 12-month operating earnings peaked in Q2 2012 at $98.69 and has been declining ever since. Q3 2012 checked in at $97.40 in trailing 12-month operating earnings and Q4 2012 was $96.82. We have just begun the Q1 2013 reporting season and will soon know whether the $98.03 estimate can be achieved.

Of course, since market participants are always looking ahead, and analysts routinely do their part to ensure rosy forward earnings estimates, there is usually the allure of "cheap" looking price-to-earnings ratios. Perhaps this reporting season will be the one in which investors once again return to caring about earnings. But, then again, market pundits are very good at creating story lines to make it seem as if stocks are always a good buy. We recently lived through the "Great Rotation" that never was. Now, we are already starting to hear pundits come up with the next reason to ignore earnings and an anemic macro picture and buy stocks: Japanese investors diversifying into U.S. equities. If that fails, we might hear about falling gasoline prices being a tailwind for the consumer and good for stocks. And if gasoline prices rise, it will be indicative of a recovery and good for stocks. Should none of that work, then we'll hear yet again about the S&P 500 yielding more than a 10-year Treasury or about the recovery in housing or about the "trend being your friend." Should none of that convince you to buy stocks, pundits can always point to the anemic macro-outlook as a positive for stocks because it means the Fed will keep its unconventional monetary policy going for an unconventionally long time.

With all that in mind, are you ready to capitulate and buy some stocks? Is the pain from not getting long at the beginning of the year so great that you don't care anymore if you buy and stocks go down as long as everyone else isn't getting rich and leaving you in the dust? If so, before you enter that "Buy" order, you might consider changing it to a "Sell-to-open" order.

As the title of this article suggests, there is a way to buy stocks on "sale" if you so choose, and if you are willing to look past a few risks associated with the strategy. By "sale," I am referring to purchasing a stock (or ETF) at a price that is lower than the market is currently offering.

Typically, when you read investing articles about selling puts, they are centered on selling at-the-money or out-of-the-money puts with the hope of those options expiring worthless. By selling a put option, you have the obligation to purchase a security at the strike price you sold, should that security close below that strike price on expiration (and you haven't closed the position), or should you be assigned shares prior to expiration. At-the-money and out-of-the-money puts refer to strike prices that are near or lower than the current price of the underlying security. For example, if SPY is trading at $159, a $159 put option would be considered at-the-money, and a $150 put option would be considered out-of-the-money.

The strategy I would like to describe concerns selling in-the-money put options with the hope of those puts not expiring worthless. Instead, you want to be assigned shares. Whether you are one of the investors who missed the latest rally and wants to get long or are any other investor looking to add to a position, by selling in-the-money put options, you have the opportunity to get long the stock (or ETF) of your choice at a lower price than it is currently being offered. Here is how you do that:

Using the well-known S&P 500 ETF, SPY, as an example, let's take a look at the January 2015 expiring put options. If you are about to get long at today's price of $159.30, you might also consider getting long the market by selling the January 17, 2015 expiring $180 puts for $29.37. Should you do so in a cash account, your broker will hold aside $180 per share and deposit $29.37 (minus commissions) into your account upon settlement.

If SPY continues higher and closes above $180 on expiration, you will keep the entire $29.37 and have no further obligation. Under that scenario, you will have made 16.32% in approximately 21 months on the money held aside by your broker. That's an annualized return of roughly 9.32%.

Should SPY continue higher from today's level but not close above $180, you will be assigned shares of the ETF (as you hoped to be) and be long SPY with a cost basis of $150.63 (excluding commissions).

Additionally, in the event SPY is trading lower than it is today on expiration, you will be assigned shares (as you hoped to be) and be long SPY with a cost basis of $150.63 (excluding commissions).

Of course, by selling puts rather than making an outright purchase, an investor will not collect a dividend from the underlying security. Therefore, when executing this strategy as a way of getting long at a price lower than the underlying's current price, it is important to be aware of how much in dividends you will be missing out on by selling puts. In the case of SPY, using the current forward indicated dividend rate of 2.16% will help us figure out how much in dividends the put seller is passing up. By selling puts instead of buying SPY outright, a put seller would miss out on roughly $6 in dividends. Using the recent price of $159.30 and without accounting for taxes (you would have to pay federal and state taxes on the dividends), collecting $6 in dividends would bring an investor's cost in the position (not cost basis) to $153.30. This means that even after adjusting for dividends missed, the put seller's cost basis of $150.63 is lower than the outright purchaser's cost in the position.

Another advantage the put seller has over buying shares outright is that no taxes are due on the put premium collected until the option expires worthless, is closed, or, if assigned shares, until the position in the shares is sold. Therefore, if you successfully get assigned, you would, in effect, be capturing the dividend paid by SPY over the 21 months you were short the put and not have to pay taxes on it. This is because the amount of the dividend that is theoretically built into the option's price is then rolled into your cost basis on the assigned shares. In other words, if you want to delay having to pay taxes on dividends (since the dividend is theoretically built into the option's premium), the IRS gives you a way to do it: Sell puts that you have a good chance of getting assigned on.

Here is the specific wording from IRS Publication 550 concerning cost basis and taxes for option writers (sellers):

"Writers of puts and calls. If you write (grant) a put or a call, do not include the amount you receive for writing it in your income at the time of receipt. Carry it in a deferred account until:

Your obligation expires;

You buy, in the case of a put, or sell, in the case of a call, the underlying stock when the option is exercised; or

You engage in a closing transaction.

If your obligation expires, the amount you received for writing the call or put is short-term capital gain.

If a put you write is exercised and you buy the underlying stock, decrease your basis in the stock by the amount you received for the put [emphasis added]. Your holding period for the stock begins on the date you buy it, not on the date you wrote the put.

If a call you write is exercised and you sell the underlying stock, increase your amount realized on the sale of the stock by the amount you received for the call when figuring your gain or loss. The gain or loss is long term or short term depending on your holding period of the stock.

If you enter into a closing transaction by paying an amount equal to the value of the put or call at the time of the payment, the difference between the amount you pay and the amount you receive for the put or call is a short-term capital gain or loss."

Let me anticipate three concerns investors may have with this strategy:

1. The holding period, for the purpose of determining a long-term or short-term capital gain on the underlying shares (if assigned), begins after assignment. Since this strategy is meant for investors with a very long time horizon, that concern can be brushed aside as long-term investors will easily hold for more than one year after assignment.

2. If you are not assigned shares of the underlying and take a profit on the position, it will be considered a short-term capital gain. This is a fact that investors interested in this strategy will have to grapple with. Perhaps it would give some investors an even bigger incentive to carefully select the strike price sold in order to lessen the chances of assignment.

3. The biggest concern for many investors is likely to be that they might not get assigned and miss a big rally beyond the strike price they sold. Remember that under the scenario outlined above, in which SPY moves above $180 on expiration and you are not assigned shares, you will still make money (a respectable amount of money). But you won't make as much as you potentially could have had you held the shares outright.

The S&P 500 (NYSEARCA:IVV) isn't the only index to which this strategy can apply. Lately, investing in Japanese equities seems to be all the rage. If you are a bit nervous expressing a single-country view (by buying EWJ, for example), but want exposure to Japan, you might consider an ETF like the iShares MSCI EAFE ETF, ticker symbol EFA. This ETF has a 21.35% allocation to Japan. Should you want to purchase this ETF at a lower price than it is currently trading, selling the January 17, 2015 $65 puts might be of interest. They are currently bidding $9.85. Should you be assigned shares of EFA, this would result in a $55.15 cost basis (excluding commissions), 8.95% lower than it was recently trading. If EFA marches higher and is trading above $65 on expiration, you will still get to keep the premium of $9.85 (excluding commissions), a 15.15% return on the $65 per share your broker will set aside in a cash account. Again, as was illustrated above, you would want to account for the dividend when choosing a strike price that satisfies your expectations.

The iShares MSCI Emerging Markets ETF (NYSEARCA:EEM) is another ETF representing a broader index that you might be interested in purchasing at a price lower than it trades today. If so, the January 17, 2015 expiring $49 puts are interesting. Currently bidding $9.15, should you end up being assigned shares of EEM, you would be long with a cost basis of $39.85 (excluding commissions). At the moment, EEM is trading at $42.57.

Finally, if you are a believer that small cap. stocks over large cap. stocks is the way to invest, the popular iShares Russell 2000 ETF (NYSEARCA:IWM) is a fund you likely follow. It is currently trading at $94, a bit lower than its $94.96 nominal all-time high achieved on March 15, 2013. The January 17, 2015 expiring $110 puts are roughly 17% in-the-money and are bidding $21.32. The bid-ask is spread is wide (72 cents), which leads me to believe an investor would be able to find hidden liquidity and therefore a better price than $21.32. But for simplicity's sake, let's stick with $21.32 as the price at which an investor would get filled on a sell-to-open order. By selling the $110 put for $21.32, you would be long IWM (upon assignment) at a cost basis of $88.68, which is 5.66% below today's price. If you are waiting for a 3% to 5% pullback to get long shares of IWM but aren't sure whether that pullback will come from higher prices than IWM is at today, selling the $110 put is something worth considering.

It is important to remember that the specific numbers mentioned in this article are less relevant than the strategy itself. I wanted to demonstrate the strategy across multiple ETFs representing broad-market indices, and, at the same time, provide an idea for those investors who may have missed the incredible rally certain indices have had and are about to capitulate (and buy stocks at today's prices).

Naturally, when you are interested in buying a financial asset, you would like to buy it on a pullback. Also, it is natural that everybody has their breaking point-a point at which they simply cannot stand to watch the asset they wanted to purchase at lower prices go any higher without owning some of it. I have had the idea for this article for quite some time but saved it for today because I imagine a lot of people are getting very close to capitulating and buying stocks after the relentless rally we've had.

I hope you find this strategy useful should the time ever come that you simply cannot wait any longer for a pullback and feel like you have to buy. And, on a final note, keep in mind that often times the moment of capitulation (especially for very patient people) occurs near the moment at which things tend to reverse course. Regardless of your view of today's asset prices and valuations, remember this during your future investing endeavors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Additional disclosure: I am long numerous individual stocks and an Emerging Markets ETF not mentioned in this article.

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