Last week, we sold some puts on NAB, which is a stock in the financial sector. To manage risk, we plan to build a diversified stock portfolio as diversification across different sectors is one of the ways to reduce risk in a stock portfolio. Hence, this week we will sell puts on a stock from a different sector.
Trade Transactions This Week
Rio Tinto: RIO July $64.00 put
The materials sector has taken quite a beating since early February so I decided to go shopping for bargains in this sector. Of all the materials stocks on my watch list, I liked RIO the best. It is a fundamentally good stock which is valued at $76 per share by Vector Vest, the stock analysis tool I use for stock selection. Hence, RIO is considered undervalued at today’s price of around $66.
From the chart below, it looks like RIO has good support (green line) at $60 and the “double bottom” technical pattern and a mild short-term uptrend (red line) further supports a bullish outlook for RIO.
Even though I am bullish on RIO, I would like to manage my risk further by buying RIO at a discount. I looked at the options chain (see below) for RIO and found that I could sell an OTM July $64.00 put for a premium of $2.04. This means that if this put option gets exercised in July, I will have to buy RIO shares at $64 (which is $2 below the market price today) but the real cost to me would be $61.96 ($64 strike – $2.04 option premium). This is a 6% discount to the market price today which is my “safety buffer” in case my bullish analysis for RIO is wrong.
As you can also see from the options chain above, I could get more premium if I sell an ATM $66.00 put (like I did for NAB last week). However, RIO does not have a high dividend yield like NAB so I am not that keen to own the stock in this sideways market. There is overhead resistance for RIO at around $70 and I expect RIO to trade in a range from $60 to $70 for some time. RIO will go ex-dividend in August which means I will get to collect a dividend if my puts get exercised in July. However, from RIO’s dividend history shown in the table below, RIO will most likely declare an interim dividend of around $0.50 in August which is not particularly attractive to me. RIO’s dividend yield is around 3% which is less than the 4.75% interest I can get for my cash. As RIO can be a rather volatile stock, I prefer to have a bigger margin of safety and sell an OTM put as the dividend will not materially help to reduce my cost (and hence risk) of owning RIO shares.
As our allocation for each stock position is $30,000, we can sell 5 contracts of RIO July $64.00 puts. This means that I am making a commitment to buy 500 (5 contracts x 100 shares per contract) shares of RIO at $64 per share, and I need to set aside $32,000 of my cash to purchase the shares in case my put options get exercised in July. A portion of this cash will be required to cover margins but most of the cash will continue to earn interest in my Cash Investment account for the next three months while waiting for the puts to expire. I will receive $1,020 ($2.04 x 500 shares) for making this commitment.
My primary exit for this trade is for my put options to expire worthless in July. This would be the case if RIO stays above $64 when the option expires on the July 26. This means I simply get to keep the $1,020 of premium income which is a 3.18% return in just over three months or an annualised return of $11.72%.
My secondary exit for this trade is to buy RIO shares at $64 per share. This would be the case if RIO’s share price is below $64 when the options expire on July 26. I am quite happy to own RIO shares long term as it is a good undervalued stock.
Model Portfolio Update
National Australian Bank: NAB May 24.50 PUT
On April 11, I sold to open NAB May $24.50 put options for $0.62 when NAB was trading at $24.42. Since then NAB shares have gone up in price. Today NAB is trading at $25.15 and my put options are now only worth $0.25.
For more information about this trade set up, read last week’s Model Portfolio Update.
Current Open Position Snapshot
I will be providing a weekly update for this model portfolio on this blog. If you are intrigued by our income strategy but have trouble following the discussions in this post, you will need to first download and read our e-book in order to understand the strategy and do some basic options education (found on our Resources page) to familiarise yourself with option terminology.
Disclaimer: This post is for educational purpose only and should not be treated as investment advice. This strategy would not be suitable for stock investors who are not familiar with exchange traded options. Any reader interested in this strategy should do their own research and seek investment advice if required.