Procter & Gamble (NYSE: PG) has been an extremely rewarding stock for the long-term investors. With an attractive dividend yield of 3.21%, the stock seems like a good investment at $83 per share. But this article is not about whether the stock is a buy or a sell at the current level; instead, it is about how an investor can double his income using a limited-risk options strategy.
To explain the strategy in the simplest possible manner, I will use a couple of technical price charts, which would appeal to even the non-technical investors. And then, I will discuss the options to be considered, the expected return, and the risks involved.
*Note - For easier calculations, I will omit the commissions and the fees part. However, it is strongly advised that an investor first consults his/her broker before initiating this strategy.
One can clearly see from the monthly PG price chart below that the stock has been trading in a very wide range since 2000. Investors have been milking this range to make huge profits by employing the simple buy low, sell high strategy.
And they have been smart doing that. But I believe that while making these hefty returns, one can compensate himself richly for just the time he is willing to dedicate.
For now, just take note of the two price points obtained from the big range:
Support - $64; Resistance - $96
Using these two extremes, we will discuss an options strategy that will provide investors with an additional 3 percent income on an annual basis. The options strategy is a short strangle, which requires an investor to sell deep out of the money call and put options, both with the same expiration date.
Since I do not expect Procter & Gamble to breach this 15-year range in the next one year, I recommend selling the $97.50 call option and the $65 put option expiring on January 19, 2018.
At the current level, the $97.50 call option last traded for $0.85. The market currently sees a strong 86 percent probability of this option expiring worthless on January 19, 2018. This indicates that the market also does not believe that the range will be violated on the upside. But, as we will discuss later, even if it does cross the resistance, it would not affect the investor employing the strategy.
Now, selling this call option last brought in $0.85, which is acceptable given the bid-ask of $0.78-$0.93. Therefore, shorting the $97.50 call option will bring in $0.85.
Similarly, the $65 put option last traded for $1.88, which is also acceptable given that the bid-ask as of Monday's close was $1.80-$1.99. The market does not believe that any untoward incident would cause the stock to slump below the support on January 19, 2018; this is indicated by the 85 percent probability that the option expires worthless.
So, assuming we receive $1.90 by shorting the put option, the total income for an investor grows to $1.90 + $0.85 = $2.75.
Now, this income is until January 19, 2018. Comparing it with the current dividend of $2.68 tells us that one can almost double his income.
But should one employ this strategy immediately? NO. I think that if one waits for just some more sessions, we could see the stock dropping to $80, at which point this strategy will prove better. And I am not saying this without basis. The options data is indicating this with a higher premium allocated to the put option, which is even farther from the market price compared to the call option. Interestingly, the $92.50 call option with the same expiration date settled at $1.75.
The fact that the market is giving more value to the distant put option is indicative of the near-term weakness in the stock.
Additionally, as one can see from the weekly PG price chart below, the stock has been sliding lower since hitting a peak in October.
I have employed the Fibonacci retracements - a technical tool - to the entire run up of this stock from the bottom in August last year to the recent peak. It must be noted that the stock briefly took support from the 23.6 percent Fib retracement of $84.36 before breaching it decisively. The next strong support for the stock is at the 38.2 percent Fib retracement of $80.66.
The market has also respected $80 as a good buying level several times earlier. The horizontal black line in the weekly chart confirms this.
So, if the stock drops to $80, it would be equidistant from the support and resistance levels. Any increment in the put option will be adjusted by the decline in the call option.
At $80, if an investor is able to grab $2.75 in income as discussed earlier, the total return would translate into 3.02% annually. Since the market is weighing the put option more, it would be easier to obtain the income.
But Why Procter & Gamble?
It is clear to us from the price charts that PG is in the middle of a wide trading range, which makes it a suitable candidate for the short strangle strategy given that it entails selling deep out of the money options. Since we are expecting the stock to hold this range, it is helpful to know the beta of this stock. Yahoo Finance tells me that PG has a beta of 0.59 which means that it moves slowly as compared to the broader market.
Low-beta stocks are the best choices for this strategy since the loss-potential would be severely limited even in the face of volatility. For the same reason, I had earlier recommended AT&T (NYSE: T).
Risks To This Strategy
An investor holding PG shares and employing this strategy needs to understand and evaluate the risks clearly.
If the stock falls to the support level, he should be willing to dedicate more funds to lower his purchase or miss out on the lucrative opportunity. In that case, the decline in stock value will not be compensated by the strategy.
This strategy will provide an additional income if the stock stays above the support level on the expiration date. Below this level, it is strongly advised to cut this strategy as the short put option could bring in heavy losses.
If the stock breaks out on the upside, losses due to the short call option will be negated by the shares held by the investor.
Important Tip: Having understood the above, the investor can also choose to short a slightly nearer call option such as the $92.50 to bring in bigger income. That would boost the income significantly, however, he has to make a decision regarding losing potential stock appreciation to the short call income.
I have deliberately not included the commissions and the fees factor in the calculations. However, they can be significant sometimes. Therefore, it is imperative to carefully understand the costs involved in this transaction. Do not make this transaction if the costs are too high.
Procter & Gamble is in the middle of a very wide range. Investors can use the opportunity to make an options trade which promises good returns at limited risk. The basic premise is that the stock is not expected to break $65 on January 19, 2018. If it does, that would represent 20 percent downside from the current level.
The commissions, the fees, and the margin requirements should be clearly understood by the investor before making this trade. If they are too high, an investor must choose to not make this transaction.
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Disclosure: I/we 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.