Thursday, November 10, 2016

Recent Option Transactions

dividend growth investing, option strategy, put option, call option, income investing
Cardinal Health (CAH) and Realty Income (O) Options Transactions
As part of running this blog that chronicles my journey to financial independence I like to be open and honest with all of my transactions.  Typically that revolves around buying shares of high quality companies that I deem to be at fair value or less.  And occasionally there's a sale of a company like when I closed one of my positions earlier this month.  Being open about the moves I make allows for better discussion with all of you and helps spread ideas around.  If it creates my own "investment journal" to detail why I made the move and my expectations, well that's even better.  

Talk about a busy few hours.  As many of you know I just completed my 401k Rollover, with 500 free trades in tow, and I'm ready to get some of it working for me.  Between the last hour or so of trading on Tuesday and the first 2.5 hours on Wednesday I invested a big chunk of capital.  Well, I say invested, but the majority of investing is via selling put options.  I'd classify the moves that I made as conservatively-aggressive if that makes any sense.

Since the account is tax-advantaged I don't have to deal with the drag of the option premium being taxed at short term capital gains rates, well not until the funds are withdrawn way in the future at whatever the tax rate is at the time.  Commissions are also a big drag on the return potential; however, I was able to get 500 free trades to keep my funds at the brokerage house where my 401k was housed.  My strategy with at least half of my Rollover funds is to be rather aggressive via the options market via selling puts and calls.  

So let's run through the various moves because there's been a lot more action than normal.  I made 4 moves in total and I'll highlight the first 2 today and the second two tomorrow.

Cardinal Health, Inc. (CAH) - Buy/Write Covered Call

The first move I made came late on Tuesday, November 8th.  Cardinal Health has been making the rounds of the dividend investing community after a big drop in its share price.  In early August it was trading over $84 and at the time of writing it's down to around $68.  

The decline was largely due to the price war that is squeezing the margins in the industry.  For those that don't follow Cardinal Health they are essentially a pharmaceutical and medical supply distributor.

Company: Cardinal Health, Inc. (CAH)
Transaction: Buy/Write Covered Call 1 Contract
Date Opened: 11/8/2016
Expiration Date: 3/17/2017
Cost Basis: $65.42
Strike Price: $67.50
Option Premium: $2.98
Premium Received less Commission/Fee: $297.95

My typical option strategy is to sell put options; however, with Cardinal Health I went the buy/write route.  Buy/writes are essentially the same thing as writing a covered call on shares you already own except you do it at the same time as you purchase the shares.  By doing it at the same time you can save on commission costs, but it works the same way as doing them separate.

For those that don't use options a covered call is essentially a contract between the seller and the buyer wherein the buyer of the option has the right, but not the obligation, to purchase 100 shares per call contract at an agreed upon price on or before the expiration date.  

All call options contracts will work out one of three ways.  If the share price is higher than the strike price then the option will be executed and the seller of the option would lose out on any gain higher than the strike price.  If the share price is lower than the strike price then the option will not be executed and the seller of the option would keep the option premium as extra income and still own the shares.  The third scenario is if the share price declines significantly in the interim, then the call option would lose value and the seller of the option could buy to close the call and lock in a gain on the option.  Although they would be sitting on a paper loss on the shares; however, that should be of little concern if you purchased shares near their fair value and you don't mind owning the company over the long term.  Phew!  Talk about a mouthful.

So how can this move play out?
dividend growth investing, health care, income investing, option strategy, call option
Cardinal Health (CAH) Buy/Write March 2017 $67.50 Call Option
That's a solid 7.7% return over about 4 months which works out to over a 23% annualized return.  Not bad in my book.  Although if this were in my taxable account I probably would have taken a different approach than a buy/write.  

There's not a whole lot of additional downside protection, less than 5%, if the option isn't executed; however, there's built in downside protection since the share price has already retreated significantly.  

This company is a winner with 20 consecutive calendar years of dividend growth so I'm just fine owning them over the long term.  Especially since free cash flow is still extremely strong with over $8.00 per share generated over the TTM compared to dividend payments of $1.67.  That puts the TTM FCF payout ratio around 20%.  Even better is that management clearly lets owners reap the rewards of a growing business with the "worst" annual dividend growth rate since 2000 being 9.1%.

Realty Income, Corporation (O) - Sell to Open Put Option

The first move from Wednesday came almost right at the opening of the markets.  This move was semi-telegraphed as a possibility since I recently examined various put options on Realty Income.  I liked the "risk"/reward that some of the put options offered and moved forward with one on Wednesday to generate a solid return or buy shares at a discount.

Most anything that's a quasi-bond, real estate investment trusts included, have seen their share prices decline significantly since early August.  Much of the declines are likely related to the possibility (likelihood?) of an interest rate hike from the Federal Reserve in December.  

In my eyes that's not much of an issue for Realty Income.  For starters we're talking about a 0.25% hike up to *GASP* 0.50%.  That's not exactly close to normalized interest rates.  Also, I have lots of respect for Realty Income's management and feel they won't chase acquisitions if the numbers don't make sense.  Of course it helps that Realty Income has one of the lowest costs of capital, which is a testament to the management, in the REIT space which means at any given cap rate on purchases they generate more cash flow than those with higher costs of capital.  

Company: Realty Income, Corporation (O)
Transaction: Sell to Open 1 Put Option
Date Opened: 11/9/2016
Expiration Date: 3/17/2017
Strike Price: $50.00
Price of Contract: $1.15
Premium Received less Commission/Fee: $114.95

I really like put options as a way to essentially set a limit order and get paid for it to hit.  This works great if you've done your homework on the company and are comfortable purchasing the shares.  The big risk is something unexpected happening that alters your investment thesis, although I'd venture to guess that with many of the blue chip dividend growth companies that doesn't happen that often.  That's why I consider put options to be the best of both worlds.

So how can this move play out?
dividend growth investing, real estate, income investing, option strategy, put option
Realty Income (O) March 2017 $50 Put Option
If the share price remains above $50 then I won't have to purchase the 100 shares at $50 per share.  That's a decent, albeit smaller than ideal, return from the premium of 2.30%.  On an annualized basis it works out to a 6.70% return.  Not bad, but not excellent.  

If the share price falls below $50 then I'll have to purchase 100 shares at $50 per share.  However, thanks to the option premium I've already received that works out to an effective purchase price of the strike price ($50) - option premium ($114.95 / 100) = $48.85.  That's over a 12% discount from Wednesday's closing price.

I was willing to give up a bit of return via option premium in exchange for further downside protection via a lower strike put option.  Although, in hindsight I should have waited to see just how things went after the surprise Trump victory Tuesday night, but it is what it is.  I left a bit of premium on the table, but I'm still happy with the way things can go.  The last trade on this contract was for $1.40.

Conclusion

I have to say it's great getting to be active in the markets again now that my 401k is officially moved into my new Rollover IRA.  These were the first two moves I made with this new found capital and there's two more to report on tomorrow since this post is getting quite long.

These two moves alone represent an investment or at least exposure to over $11.5k worth of capital which is by far the most I've invested in such a short amount of time.  This is the largest amount of cash I've ever had on the sidelines and honestly I need to just take a slow and steady approach to getting it invested.  In general the markets are at best fairly valued and likely in overvalued territory, although there are pockets of value out there.  Plus there's no award for investing capital quickly, rather you generate great returns by being patient.

One other company that I'm looking at is CVS Healthcare (CVS) (Analysis Here) which looks even better down in the mid $70's than it did in the upper $80's just a few short weeks ago.  I'm trying to figure out the best way to play this whether it's sell a put option, do a buy/write, or just initiate a position with the intent to hold.  Decisions, decisions.

I've updated my Option Summary page to reflect this change.

Do you incorporate an option strategy with your portfolio by selling covered calls or writing puts?  Did you make any moves on Wednesday or did nothing strike your fancy?

Please share your thoughts below!

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6 comments:

  1. PIP,

    Thanks for the explanations. I have about 5 open option positions right now myself including 3 covered calls on PFE. I was way up until the election results. Big drug/health care companies are exploding right now. I have a feeling we both may lose our shares. Time will tell. I like that you put a fairly long time line on your trades to give you some recovery opportunity.

    MDP

    ReplyDelete
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    1. MDP,

      I might add smaller position in CAH because it's very much looking like it'll be executed, well as of now there's still a long ways to go until expiration for that contract. I tend to not write too many covered calls because there's the very real risk of having to sell your shares. So I prefer to use them to build positions although it takes a lot of capital which is the big downside to options.

      All the best.

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  2. I have toyed around with options in the past but haven't initiated any positions recently due to the recent volatility because I don't feel like I know enough to not get caught with my pants down. I am diligently studying in the meantime in case a no brainer comes across my computer screen :)

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    1. MSM,

      Using put options your risks are relatively limited. The biggest risk is that a company specific issue crops up that just crushes the position and really impairs the long term value of the business. I'd venture to guess that doesn't happen too often with many of the blue chip dividend growth companies.

      So that really leaves you with market risk that moves the share price even lower than the strike price less the option premium you received. But if you structure the contracts right, i.e. at price points you'd buy anyways, it's not anymore risk than if you just purchased the shares at that price when it came down to it and then just continued lower.

      Although due to the amount of capital we're talking about it doesn't lend itself to the slow and steady DCA approach of building positions up over time. So you can be stuck with a liquidity crunch and lack of capital at just the time you'd love to be in cash.

      All the best.

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  3. I like both trades. Decent premiums for the risk. The way O is dropping you may just get 100 shares at $50 with a premium. I really like how you integrate (executed vs non-excecuted) outcomes in your posts. I may need to steal this idea. Best of luck with both trades.

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    Replies
    1. IH,

      So far it looks like the CAH move is leaving a lot on the table, but there's a long ways to go until expiration.

      It really helps me to look at what happens in both situations to determine whether it's worth the "risk" especially when selling put options. I think it really gives clarity to just how the option can play out.

      I'd love to load up on some more options since I have lot of capital now but through these 2 moves and the 2 I highlighted today I "invested" nearly $40k of capital which is crazy. So I need to slow my roll a bit and look for values. Ideally I'd use about 50% of this capital to build up some core positions and then the other 50% would be used for more options trading.

      All the best.

      Delete