Updated Enhanced Income Strategy For Chevron And JCI Controls

Includes: CVX, JCI
by: Mark Bern, CFA

By Mark Bern, CPA CFA

We've tried selling puts twice on both Chevron (NYSE:CVX) and JCI Controls (NYSE:JCI) and thus far have seen those contracts expire worthless; but we did collect the premiums on the puts we sold. But that is part of the strategy: earn cash returns of at least 8 percent per year (preferably 10-12%) until we get the stocks at discounts to the current market price. In this article I will start by reviewing the results of what we have done thus far with these two excellent companies' stocks and then I will provide my most current recommendations based upon the closing quotes on Tuesday, April 24, 2012. Generally articles are published within 24 hours of submission so the recommendations in my articles should still be close to what is available in the market at the time of publication. I try to always use closing prices because that reduces the opportunity to "cherry pick" the best prices of the day.

For those who read my earlier articles on CVX here, you will recall that I continue to believe that CVX is a well-managed, dominant company with exceptional upside potential. I like the long-term prospects for integrated oil, and CVX especially. My reasoning is explained in greater detail in the first article (you can link to the earlier article from within the article linked above).

In the first article, when I first recommended CVX on September26, 2011, the stock price stood at $91.49. The April 24th closing price was $103.03. At this juncture, the argument can certainly be made that we should have just bought the stock at the time. The same can be said for many of my recommendations in this series. But the true measure of the strategy will be how portfolio returns fare relative to the buy-and-hold strategy over time. I periodically write summary articles for this series that compared the returns of both so readers can see how things are going as time passes.

On September 26, 2011 we sold one CVX November put contract with a strike price of $85 for a premium of $3.35. The option expired worthless and we pocketed $326 (net of commissions) for a return of 3.5 percent on the $8,500 we held in our account to secure the put contract. Had the contract been exercised we would have been obligated to purchase 100 shares of CVX at $85 a share which would give us a cost basis of $81.65 ($85 - $3.35). That would have been a discount of 11 percent. But the contract expired worthless, so all we got to keep was the premium of 3.5 percent over a holding period of less than two months.

Then, on November 30, 2011, we sold another put contract, this time with an expiration of March 16, 2012 and a strike price of $87.50 for a premium of $2.46 per share. We collected $237 (net of commissions) and held the position for under three months for a return of 2.3 percent. So, thus far we have collected a total of 5.8 percent on CVX without holding the stock. Had this option been exercised we would have been obligated to purchase 100 shares of the stock for $87.50 a share and a cost basis of $85.04 ($87.50 - $2.46). But, alas, the contract expired worthless once again so we need to make another attempt and reap the rewards of being paid while we wait yet again. I'll make my recommendation later in this article.

But first, let me review what we've done with JCI Controls to date. You can access the previous update on JCI here and proceed back to first article through the ink provided in the previous article. We have sold puts on HCI twice and both time the contracts have expired worthless allowing us to retain the option premiums as a return on the cash we held in our account to secure the puts.

In the first article I explained in detail why I like JCI as a potential long-term holding. The stock price then stood at $28.96 a share and now stands at $31.02. Free cash flow turned negative in 2012, so I will be keeping a close eye on the cash flows reported in the quarterly reports, but I maintain that JCI remains a well-managed company with excellent upside potential and a dividend that just keeps on rising year after year.

We sold the first put option contract on JCI October 6, 2011 with an expiration in November and a strike price of $25 a share for a premium of $1.20, or $111 (net of commission). That was a 4.4 percent return on the $2,500 cash we held in our account to secure the put for a holding period of less than two months. Of course, if the contract had been exercised we would have been obligated to purchase 100 shares of the stock at $25 per share. That would have given us a cost basis of $23.80 ($25 - $1.20).

We next sold the second put option on December 28, 2011 with an expiration of April 2012 and a strike price of $30 for a premium of $2.30, or $229 (net of commissions). That gave us a return of 7.4 percent on our $3,000 cash held in our account to secure the put. If the contract had been exercised we would have been obligated to purchase 100 share of JCI for $30 per share for a cost basis of $27.70 ($30 - $2.30). The price of the stock on the day we sold the put was $30.65.

Today I want to sell a put option on CVX with an expiration of September 21, 2012 and a strike price of $97.50 for a premium of $3.95. That will provide approximately 3.96 percent over the next five months, a little lower than what I prefer but still within a reasonable range for this stock. This equates to an annualized return of about 9.5%. If the contract is exercised before expiration we will be obligated to purchase 100 shares of CVX at $97.50 per share for a cost basis of $93.55 ($97.50 - $3.95). I realize that this is 2.1 percent above the price we could have paid back in October and on a single stock basis we may have been better off just buying the stock back then. But this whole exercise in one in portfolio strategy where we need to look at the reduced risk of holding a diversified equity portfolio and measure success on the basis of return on the whole portfolio over time. Only time will tell if this strategy holds merit over buy-and-hold. We have also collected 5.8 percent in premiums over the last seven months instead of the annual dividend of 3.2 percent. This helps offset the lost opportunity thus far.

The next recommendation I want to make is to sell a JCI put option contract that expires on July 20, 2012 with a strike price of $29 for a premium of $1.05. That will net us $96 after commission for a return of 3.3 percent over a holding period of three months. If the contract expires worthless, this will bring our total return thus far to 15.1 percent over ten months without holding the stock. If the option is exercised we will be obligated to purchase 100 shares of JCI at $29 per share resulting in a cost basis of $27.95 ($29 - $1.05). But remember, we have collected 11.8 percent on the stock previously during that past seven months and the yield on the stock is still only 2.3 percent at the recent closing price of $31.02.

The strategy has definitely worked well on JCI since the inception of this series and has done okay on CVX during that time period also. I point this out to drive home this point once again: it is the total portfolio return that matters, not the return on any one individual investment. The other major factors are time and volatility. Volatility comes and goes in the equities market. If applied appropriately, I believe this strategy can help us to reduce the volatility in our portfolio relative to that experienced by the broader market. Regarding time, my original idea of keeping this series going for two years is probably much too short to prove much. I probably should be ten years, at least. But that would be more than I want to commit to at present. Thus, I decided to commit to the first two years and then play it by ear, if you will, from there.

As is my custom I believe that is important that I include a warning in my articles in this series to make sure that everyone understands that there are risks to every strategy, including this one.

First, as has been pointed out in the comment threads to previous articles, there is always the possibility that the selling puts strategy may not result in the purchase of the desired stock in a rapidly rising market. An investor could miss most, if not all, of a run up. It is doubtful that the full run will be missed, however, since the market (including most stocks) correct by 10 percent or more usually one or more times per year. For that reason it is likely that the investor will purchase the stock at some point during a bull market, but they still may miss some portion of it (perhaps a large portion, especially in a bounce off a major bottom). On the positive side of this equation is the fact that as most major bottoms occur there is usually a day of capitulation. Capitulation days are generally heavy down days on which, if one has sold puts outstanding, the investor stands a good chance of being put the stock (purchasing at the bottom). There are no promises of that happening, but the odds are better under this strategy than following one's gut emotions. One other thing that helps offset the possible regret of missing a stock at a good price is that the seller of the puts will continue to earn a decent return on their cash (generally 8-10 percent on average) annually while they wait. Granted, that is not as good as hitting a 30 percent gain in a good year, but it sure beats sitting in a money market and earning zip.

Second, as has also been pointed out in the comment threads, it is possible to end up buying a stock when the stock market tumbles and having to ride it out to the bottom. If the investor is buying a stock in a company that they want to hold for the long term, at least with this strategy they will never buy at the very top. After all, we're selling puts at below the price when the put option is sold. In addition, the investor has the opportunity to sell calls and, including dividends, receive an average of 8-10 percent in cash payments per year while they wait for the stock to rebound. If we have done our homework in picking a good company at a price that represents a good value, then the likelihood of a rebound is very strong. Practically the only way to end up losing money is by selling the stock. If you hold, you're getting paid well to do so and eventually you'll be back in the money. If the investor had purchased the stock outright at the top of the market and the market fell 50 percent, they would be down 50 percent at the bottom and need the stock to double just to get even. If they are selling calls all the way down, assuming the average length on most bear markets is about 17-19 months, the investor should have collected somewhere in the vicinity of 15 percent along the way, putting them down 25 percent at the bottom. Remember, you bought at 10 percent below the top, using puts, so you couldn't lose the full 50 percent in any event. Now you only need half as much of a rebound to get even.

The third scenario is the worst case. If an investor sells a put near the top and ends up with the stock at a 10 percent discount from the high and rides it all the way down to the bottom, collecting dividends and call premiums along the way. Now you are down 25 percent and you end up selling a call that gets exercised near the bottom and the stock is called away. But remember, you are selling calls that will net you about 10 percent above the stock price at the time the option is sold; therefore you should be selling at no less than 10 percent off the bottom. That would result in a total of a 15 percent loss on the total of your transactions. Now compare that to most alternatives other than picking the tops and bottoms, which no one can do consistently.

An alternative to riding a stock down is to use stop loss limit orders. I recommend that investors consider using this strategy to save themselves the pain of riding a stock down during an overall market crash. Some long-term investors with a low cost basis may not want to use this strategy due to the tax consequences.

The point is, while this isn't the most lucrative strategy, it does bear less risk of loss than most alternatives. By taking most of the emotions out of the decision process, an investor improves their chances of producing consistently higher returns. And that is the whole point. I hope this explanation helps cure some of the over-enthusiasm. This is no get rich quick scheme. It is simply a systematic strategy that can help investors achieve market-beating returns over the long term.

As always, I enjoy the comments and will try my best to answer questions if readers will take the time post them.

If you are a new reader and are confused about what strategy I keep referring to please see the first article in the series for a primer.

Thanks for reading and I wish you all a successful investing future!

Disclosure: I am long CVX.