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Options: Your Port in Rough Waters

Steven Smith

"Is it safe?"
"Tell me what the 'it' refers to."
"Is it safe?"
"Yes, it's safe, it's very safe, it's so safe you wouldn't believe it."

-- Dustin Hoffman, trying to find the right answer for Laurence Olivier in Marathon Man

After a great rush at the end of 2004 in which the S&P 500 galloped some 15% higher in the final three months of the year, investors are once again facing the choppy market. The S&P hit a three-year high in late March as earnings, economic data and a measured and watchful monetary policy suggested a period of sustainable earnings growth in a controlled inflationary environment.

But then things turned bad, thanks to a few off-key reports. The S&P has tumbled some 5.9% since late March and has seen 30-day intraday volatility reach a 14-month high.

The stock market's schizoid performance over the last few months has created a quandary for investors: Choose between chasing stocks at ever-higher levels as many did earlier this year, or step into a downdraft like the one that was delivered last Friday. Nervousness and questions abound: When and where is it safe to buy? Should we just hide on the sidelines until the all-clear signal comes? Basically, it's the age-old tug of war between fear and greed.

Create Your Own Dip in the Road

I propose that a good third alternative for lessening both the risk and pain is to consider selling puts as a means of buying stocks at a discount to the current market price without having to wait for the underlying stock price to dip. As we know, selling puts short creates a moderately bullish position in which the maximum profit, no matter how high the price of the underlying shares rise, is limited to the sale price of the put. And if the underlying price falls below the put's strike price, it also reduces the effective purchase price if the short put is assigned.

The benefit of selling puts on stocks is that it establishes a predetermined purchase level. This means you don't have to worry about second-guessing or backpedaling with "cancel if close" orders when faced with steep and scary selloffs. If you did your homework and wanted to buy shares at a certain price, selling puts is a great way to let the market come to your price. If the stock does not sell off, then at least the puts generate some marginal income through the premium collected.

Looking for a Floor

Thanks to a reader's recent inquiry using the shorting of put options as a means of patiently establishing an incrementally long-term stock holding while earning income in the short term, I reviewed the September 2003 article he referenced. (You'd be surprised at the endless amount of information, data and entertainment the site's archive contains.) In that column I ran a basic screen looking for put-selling candidates.

The concept then, as now, was that companies paying a decent dividend essentially put a floor under a stock's price. The other criteria to help cull for value led to a screen of optionable securities that included these simple parameters:

• Price-to-earnings ratio below 15 times current earnings and below the three-year EPS growth rate.


• Paying a current dividend with a yield in excess of 2%.


• An absolute stock price above $25.


• A market capitalization above $500 million.

Of course, unlike buying the shares outright, selling puts doesn't entitle you to collect a dividend. The tradeoff is that the premium yield realized through the option's price decline, whether from time, a price movement or a combination of the two, should be equal to or greater than the underlying security's dividend yield.

Looking for Some Good Buys

The original screen produced 90 names and was heavily weighted with energy, utility, real estate and money-center backs, all of which performed wonderfully for the next 18 months. Now we see the first cracks in commodity prices, the carry trade has been taken away from the banks and insurance companies are under investigation. So while the new list of 72 names still contains representation from the REIT, energy/utility and banking sectors, it's time to note some technology, consumer staples and retail companies that appear this time around.

One small company that caught my eye is Kellwood(KWD Quote), which is basically a middle-market private-label apparel maker and supplier. The stock has been suffering of late, dropping some 45% to $24 over the last year on concerns of margin pressure and weaker spending. But with the consumer showing indefatigable resilience and market leaders such as Target(TGT Quote) and Wal-Mart(WMT Quote) making it clear that private-label clothes are a priority growth category, Kellwood could be poised for a turnaround.

On Tuesday, with shares trading at $24.75, you could sell the June $25 put for 90 cents. This equates to buying the stock at $24.10, which boosts the affective dividend yield from 2.6% to 2.9% on an annual basis. Equally important, if the stock holds around $25, the premium collected translates into earning 3.7% in a five-week period. And even though we shouldn't annualize, that translates into around 36% per year if the stock just hangs around the $25 level.

Some other names on the list I am drawn to are Unilever(UL Quote), Nam Tai Electronics(NTE Quote), Wachovia(WB Quote) and Stanley Works(SWK Quote).

The first rule to remember in employing a put-selling program is to choose stocks that you would feel comfortable owning at the chosen strike price. In a sense you are hoping to be assigned. The collection of premium should be viewed as a consolation prize for not actually owning the shares of a rising company. But it can be a pretty comforting consolation.