Seeking Alpha reader DGI_Dan responding to contributor ONG Kang Wei's article " Investing In Dividend Stocks: Why I Chose The Stocks In My Portfolio - Part 4 ( seekingalpha.com/article/1143261-investi...) echoes other readers in the view that when a stock is currently above its desired entry point price the only alternative is to watch and wait.
Here I will show the way to apply the techniques of my previous instablog article
How To Buy Stocks Wholesale (SSW On Sale At 9.4% Discount) ( seekingalpha.com/instablog/6618191-richa... )
in a situation like Waste Management (NYSE:WM) at this point in time.
DGI_Dan and ONG Kang Wei and others find Waste Management an attractive long term investment for yield and growth. They agree that now is not the time to be buying and that it should be on the watch list for future entry at a more favorable price. Selling cash covered puts now is an alternative strategy providing you a more proactive lead in beating all those other investors that just watch and wait to a better entry point price. You achieve 3 advantages over the watch and wait strategy:
1. You get in line now and get a seller to agree to sell you their shares in the future if the stock retreats below your acceptable entry point at the time you select.
2. The current stock owner pays you for that option of selling his shares to you in the event of the market decline back to levels you like for entry and that seller likes for exit. Thus you act NOW and get paid to wait instead of just waiting for free.
3. The premium you get paid in selling the cash covered put effectively lowers your entry point price even more than the chosen strike price of the put contract. Thus you enter at a price lower than others that simply waited without stepping up and selling the cash covered put.
4. The entry into a contract NOW (between you and the put buyer) adds enforces discipline to your investing strategy, locking in your analysis of a good entry price and avoiding the temptation to play market timer to grab an entry at the very bottom (we really never do and often miss out entirely trying to wait that extra day or two).
On the other side, there are some flexibility costs and risks you do add by being a cash covered put seller:
A) You are short the put and thus the contract will only be enforced by the stock's owner (the put buyer) if the market has headed DOWN to and below your selected entry price (The strike price). However, you already have decided the price is to high NOW and you want to wait until it falls back DOWN to your chosen entry price. This ONLY happens when the stock goes down. So its not a negative situation, its what you wanted and insisted on being a necessary prerequisite before you are willing to buy the stock anyway.
B) Your cash to buy the stock is tied up as security guaranteeing your ability to pay for the shares if the put buyer (the stock owner) decides to present his shares to you at the contracted strike price. The premium paid to your for the put is compensation for tying up your funds during the put contract period. I look at this premium 2 alternate ways - IF the contract expires unused, then you keep the premium and that is all. It is indeed compensation for parking your money while waiting to see what the buyer decided to do with his shares over the time of the contract. On the other hand, if you are presented the stock, then I prefer to think of the premium as a discount to your effective entry price, reducing the strike price by the premium cash you received. My reasoning is that IF you could have bought the stock TODAY, you would tie up your cash and evaluate your investment performance based on entry price without discounting for time value of money. Thus you as you become a share holder upon presentation of the shares under the contract can consider and evaluate your investment the same as if you had been able to buy the shares TODAY at the effective entry price you set. (a concrete example for WM given below will make this very clear and easy even if you are a bit confused as you read it here).
C. While you remain exposed to the downside risks of the stock below your strike price the same as you would if you owned the stock long as of today at your price, Your upside reward is limited to the premium you are paid for the contract during the life of the put.
Now, having detailed the anatomy of the put, lets look at the real world trade available today in Waste Management .
First, lets pick an entry price. I will skip the fundamentals analysis since this article is being written for those who already expressed an interest in buying the shares when the price falls back to an appropriate entry level. A look at the technical chart shows that it has been trading in a narrow channel between $30 and $36 since mid July 2011, forming a classic pennant rising from the bottom to resistance at 36. Since this is a rising pennant I suggest an effective entry price at $34 to be a good target, right at the midpoint of its current trading channel range of $32 to $36 where it has narrowed since the close of December 2011.
Chart for Waste Management
Now, let's find an appropriate put option that combines a strike price minus premium received for sale of the put equal to about $34. The table below are the near term option chains for WM.
WM Puts Table:
We see that the March 16 $34 puts pay us $0.21 for an effective entry of $33.79 or alternatively the April 20 $34 puts pay us $0.40 (effective entry of $33.60).
The March $0.21 premium works out on the $34/share time value for 44 days to a 5.1% annualized yield rate for the tied up funds. The March $0.40 for 79 days gives annualized 5.4% yield rate. Personally, I do not generally trade if I can not find a minimum annualized rate of 12% ( 1 percent per month). However your mileage may vary and we will continue to examine this trade using the April $34 strike put at a $0.40 premium.
By selling short the cash covered April $34 strike put for $0.40 we lock in an annualized return on our $34/share funds tied up for 79 days of 5.4%. This is a return rate consistent with the yields on many sought after dividend stocks and indeed higher than the actual dividend yield for WM. In the event the stock does pull back during our 79 day contract period and we are presented the shares for our purchase at $34 per share, we will have achieved our goal of entering the stock for an effective entry price of $33.60.
Should the contract expire unused then we pocket the 5.4% annualized yield rate and look at the then current stock charts and option pricing to repeat this whole exercise again. Thus, we may go many months and many option contract cycles without every owning the stock but still obtaining a 5.4% or better annual yield from it while NOT owning it instead of just waiting on the sidelines and earning nothing while stockless -that would indeed be a WASTE.
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. I have no business relationship with any company whose stock is mentioned in this article.