Diving for Dollars

With so much uncertainty in the world right now, one of the hardest tasks for investors is trying to determine the best place to invest one’s hard-earned dollars. Recently, I read an article about the the extraordinary length of time it will take to recoup one’s initial investment when investing in dividend paying utilities. Though I could see the author’s point of view, areas in which I would take issue would be with dividend reinvestment and with the effects of compounding. Those issues aside, however, the article made me think (i.e. rethink) about the importance of not losing money.

If your were to invest in a stock and it were to, for whatever reason, drop in price by 50%,  it would then need to rise by 100% just for you to break even. For example: Let’s say we buy 100 shares of ABC’s stock for a price of $50.00 per share. If, the following week, a major news event caused the stock’s price to drop by 50% to $25.00 per share, it would then need to rise by 100% for you to simply break even (25.00 + 100% = 50.00).

If you have ever read Warren Buffet’s rules for making money (Rule #1: Never lose money, Rule #2: Never forget rule #1), you now know why it is so important to try and contain losses. Anyone who has watched stock market moves over a period of time knows that stock prices rarely ascend in a hurry. Rather, they increase slowly over time. The opposite, however, is true regarding their descent in price. Downside moves are usually rapid and quite dramatic.

With that fact in mind, one of the strategies I try to employ when there may be a limited number of options contracts available for a particular stock is [private] selling Covered Calls that are deep in the money. For example, recently I placed the following trade on Atlas Pipeline Partners, LP (APL):

Purchase 100 share of APL at $37.90 per share (Commission = $0.57 — Gotta love Interactive Brokers!)
Sell 1 MAY 18 ’12 35 Call for a price of $3.40, or a $340.00 premium (Commission = $0.63 — Ditto!)

Essentially, if (or when) the shares are called away, I will make $50.00 on each contract. How is that possible you ask? Well, it works like this:

3500.00 (strike price) – 3790.00 (purchase price) = -290.00 (Loss on the stock)
However, add the $340.00 premium to the equation and I end-up making $50.00 (-290.00 + 340.00 = 50.00). Taking into consideration the aforementioned commissions, I actually end-up making $48.80.

Well, it’s only 50 bucks you say (actually $48.80). True! But how often do you find an investment that will earn you a $16.67 dividend payment each month? Think about it: 50.00 / 3 (the number of months until the option expires in May) = 16.67. Now, I realize there will be those who will say: Yeah, but what if the stock’s price drops below $35.00 per share — you’ll be stuck with the stock. And that would be true. However, APL is a large natural gas pipeline operator that currently offers a quarterly dividend payment of $0.55 per share, for an annual yield of 5.95%. Not too shabby, and not a company I would mind holding onto for some time.

The other nice thing about APL is that its financials are in pretty good shape. Both, its debt and its long-term debt ratios are low (each, currently at 0.41%). It’s P/E Ratio is a very modest 6.95%. It’s Dividend Payout Ratio is a very comfortable 10.21%. And its Earnings Per Share (EPS) figures have been steadily improving.

Also, if you look at the chart on the right (click to enlarge) you will see that APL’s stock price has steadily increased from the low ($2.36) it made on 3/6/2009 to today’s average price of @ $37.00 — a 1568% increase! (Don’t you wish you purchased the stock in March of 2009? I do!)

The reason I like to sell deep in the money Covered Calls is because (generally speaking) stocks that make BIG moves down usually recover somewhat over the short-term. The reason for this is because the Short Sellers (whether a person or a computer program) will usually want to cover their positions and take their profits; and doing so has the effect of driving up the stock’s price (at least in the near term). Therefore, it is less likely that you will get stuck in a losing position.

A Cautionary Note: This type of strategy works best when using short time horizons. Given that the stock market is a dynamic, ever evolving beast, you would not want to employ this strategy with options contracts that have expiration periods greater than a month or two.

The last point that needs to be made here is that, if all goes as planned (i.e. if the stock’s price does not drop below the $35.00 strike), the most you will make on the trade (in this particular case) is $48.80. In other word, you profit is capped to the difference between the loss on the stock and the premium you take in (thus, you want that premium to be as high as possible). Personally, I’m okay with that because it will give me the opportunity to take my funds and try to put on another similar trade which will allow me to earn a similar dividend.

Note: Chart & Options info courtesy of optioinsXpress

Disclosure: I own the positions noted above.

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