If you have been reading the articles and reviewing the recommendations on the site, by now you should have noticed a distinct pattern. Just about every option or dividend play is on a Blue Chip market dominator. There is a reason for that. We like to invest in companies that have the biggest market share and a history of consistent corporate and dividend growth. With all those factors, it is hard to lose. These are stocks we WANT to own even if we are in it for the option premiums.
That's why we call these types of companies Digital Utilities. They have nearly guaranteed profits. If you're going to use the tools of our modern digital age then you have no choice but to use these companies' products and services. (Try boycotting all Intel products, for instance. You can't easily do it.)
Specifically, we're going to use Cisco to trade the sector. Cisco makes the switches and routers that allow the Internet to work. We've traded this company in the past. So I won't spend too much time talking about what it does. What's more important is just how today's market sets up the perfect opportunity to open a position on Cisco.
First, rising interest rates will help – not hurt – its profits. Digital Utilities generate and hold tons of cash. That means they don't need to borrow money. So rising interest rates won't increase their borrowing costs.
Even better, rising rates will allow Cisco to earn higher returns on its cash balances. Even a rise of 1% will mean big money on the billions of dollars it holds in cash. An extra 1% in yield would add an extra $500 million to Cisco's annual earnings.
And if the Fed does begin to taper its bond buying, that will mean the central bank has seen significant signs of an economic recovery. Corporate clients are critical to Cisco. So far, business investment in technology products has started to show signs of life, but it's still well below what we'll see with a healthy economy.
Here's How the option trade for Cisco works:
Today, I recommend you...
Sell, to open, the Cisco (CSCO) November $24 puts for around $1.15 with the stock trading around $24.
The puts obligate you to buy CSCO at $24 a share if the stock falls to less than that by option-expiration day (November 15). Selling these puts gives you $115 in your account per option contract. (Remember... one option contract equals 100 shares of stock.)
Buying 100 shares at $24 each represents a potential obligation of $2,400. To put on this trade, you will have to deposit a "margin requirement" – essentially a security deposit that reassures the broker that you can cover your potential obligation. It usually runs about 20% for put sales. (In this case, 20% of $2,400 is just $480.)
Here's the math...
Sell one CSCO November $24 put for $115.
Place 20% of the capital at risk in your option account, $480.
Total outlay: $365.
If the markets remain unchanged and CSCO trades for more than $24 on November 15, you won't have to buy the stock. You keep the $115 premium (and the $480 margin). That's a simple 24% return on margin in less than three months. If we put this trade on every three months – assuming all prices remain the same – this could return 96% a year on the margin amount.
If CSCO trades for less than $24 on November 15, you'll keep the $115. But you'll have to buy CSCO stock at $24 per share. So you'll own CSCO at $22.85 (the $24 strike minus the $1.15-per-share premium). Here's how that scenario works out for each option contract you sell...
Initial income from sold put premium of $115.
Purchase of 100 shares of CSCO at $24 is $2,400.
Total outlay: $2,285.
The cost ($22.85) is roughly 4.8% less than CSCO's current market price. This gives a huge amount of downside protection on a company that mints money. Plus, if you become a shareholder, you'll also receive the company's $0.68-per-share annual dividend. If CSCO pays its expected dividend over the next 12 months, you'll receive a total of $183 ($115 in premium plus $68 in dividends) on a $2,400 investment... 7.6% cash on your investment in the first year. And we'll likely sell call options against the stock to further boost our returns.
Note: The prices in this example reflect morning trading on August 23.
IRA Alternative for CSCO
If you're using an IRA or Roth IRA that bars you from selling puts, you can open an alternative covered-call position... (These alternative trades can also be done in your regular brokerage accounts.)
This is the same strategy we use to generate income on stocks that are put to us but if you prefer to start by owning shares and selling calls, the trading strategy works just as well. The math is nearly identical and the returns are similar when you sell puts versus covered calls (in terms of your potential obligation, the so-called "capital at risk"). As always for each trade, execute either the call or put trade, but not both.
Remember with covered-call selling, you are selling a call option and simultaneously buying stock. Thus, the option is "covered" with stock. And when you enter the trade in your trading platform, you should do it as a combination buy/write, or covered call.
This means you will be paying for the stock minus the premium you receive for selling the option – what's called a "net debit." Here is how the CSCO trade works as a covered call:
Buy 100 shares of Cisco for about $24.00, and
Sell, to open, the CSCO November $24 calls for about $1.00.
This represents a total outlay (or "net debit") of $23 (the $24 stock price minus the $1 we receive from the call premium). Remember... you are buying 100 shares of the stock for every call option you sell against it.
Here's how the math works:
Income from sold call premium of $1 is $100.
Purchase of 100 shares of CSCO at $24 is $2,400.
Initial outlay: $2,300.
If CSCO shares sell for $24 or more on November 15, the stock will be "called" away from you at $24 a share. This gives you a net gain of $1 per share on the position (the difference between our initial outlay and the price at which you sold your shares). This is about 4.2% in less than three months, for an annualized return of about 16.7%.
Of course, if the stock trades for less than $24, your calls will expire worthless and you'll still own the stock, uncovered. You can keep the $1 premium and the future dividend stream from 100 shares of CSCO. That should amount to $68 a year per 100 shares. This is a total of $168 (the $100 premium plus the $68 dividend) on a $2,400 investment, or about 7% this year. As always, put no more than 5% of your portfolio into this position. And hold it with a 20%-25% stop loss.
What to Do if Prices Move
In the example above, we're giving you the most recent prices as of mid-morning August 23. However, we realize prices can change by the time you go to open a position. If there are small price moves, you can still enter the trade. Just pay attention to the initial outlay – the net debits and credits described above.
Try to keep your net debit (in the case of covered calls) at or less than what we recommend. The credit for opening a put sale should equal or exceed what I described above.
For example, we recommend selling the CSCO November $24 call for around $1 with the stock trading at $24. This gives you an initial outlay of $23 a share. (The $24 stock price minus the $1 premium.)
If on Monday, the stock moves up to $24.50, you'd want to receive a premium of about $1.25. This would give you an outlay of $23.25. Keep in mind that as we get closer to option expiration day, the option loses time value, so your outlay may be a bit more than what we recommend. Similarly, if the stock moves down a dime or two, you'll pay less for the stock, but also get less for the call option.
The following table will give you a rough guide for prices we think represent good opportunities to open the recommended Cisco position over the next few trading days.
Last month, I predicted volatility would rise later in the summer as Wall Street gets back to work; and the move is good news for us. When volatility is higher, we make more money on option premiums.