Harvest Nice Gains while Offsetting Risk
Basic option selling can reward investors while also mitigating some degree of risk. This effect is magnified when writing both calls and puts with the same expiration date and on the same underlying shares. This is true because at least one of the option buyers has to be wrong when expiration day rolls around. If the shares are above the strike price when the option expires they cannot also be below that same number. In many cases the stock in question may finish close enough to the chosen strike price that both call and put buyers end up losing money.
Selecting a good underlying stock is critical. An undervalued company is more likely to go up over time. Shares that pay dividends create income which reduces absolute risk and dampens downside.
Agricultural equipment manufacturer Deere (DE, Financial) provides a great vehicle for buy/write investors after pulling back from a January high of $95.60 to last week’s close at $87.72. The company’s long-term results have been stellar.
Deere now trades for just 10.3 times the projected EPS for the FY ending this October. DE’s quarterly distribution was raised to 51 cents recently putting the current yield at an attractive 2.33%. The next ex-dividend date comes on Tuesday, March 26.
Buying shares at $87.72 while selling Jan. 18, 2014 $87.50 calls and puts makes for a healthy combination play. The best-case outcome will be obtained if the shares simply remain unchanged early next year.
Note: I’m counting four quarterly dividends if DE remains below the strike price. I assumed just three in the prior, best-case scenario, due to potential early call exercise if DE is trading well above $87.50.
A quick glance at the chart below shows that Deere has spent most of the past 15 months well into profitable territory based on the break-even point of $79.32.
The near-the-money buy/write combination allows for a greater than 21% total return while protecting against the first $8.40 per share (-9.5%) of loss if things don’t go as well as expected.
Disclosure: Long DE shares
