Note to new readers: This is a regular update on the status of our Low Risk Income Model Portfolio which is built using the income strategy described in our e-book “A Low Risk Income Strategy for All Economic Conditions”

Two weeks ago, we looked for defensive stocks and sold some put options on Wesfarmers which is a stock in the Consumer Staples sector. This has worked well as the markets have taken a tumble since then and the defensive stocks have held up well. As always, mining stocks were the most volatile and RIO has fallen over 6% since we opened our position on RIO. For this income strategy to work well, it is best to have a diversified portfolio with a heavier weighting towards defensive stocks. As the markets are currently quite bearish, I would prefer to sell puts on another defensive stock but most of the ones on my watch list such as Telstra, CSL and Woolworth have already shot up in price so I prefer to wait for a better entry point.  Instead, I decided to sell puts on another beaten up mining stock which I think may be close to hitting bottom.

Trade Transactions This Week

Newcrest Mining: NCM July $24 PUT

As you can see from the chart below, NCM has fallen over 40% since August 2011. According to Vector Vest, the current value for NCM is $35.18 so the stock is very undervalued at the current price of $24.24. Even though it is undervalued, NCM could fall further but looking at NCM’s 5 year chart I can see that it has only stayed below $24 for only a few months in the past 5 years so I am reasonably comfortable with buying NCM at $24.

Furthermore, although NCM is a mining stock, it is primarily a gold producer. With austerity measures not being so popular, central banks are likely to print more money which could lead to high inflation in the future. Hence, I would be happy to have some exposure to gold through my stock portfolio.

As you can also see from the options chain below, I can sell a July $24 put option for $1.24 per share. If my put options get exercised in July, my cost basis for these NCM shares will be $22.76 ($24 strike – $1.24 option premium received).

Source: CommSec (click on the chart to enlarge)

As our allocation for each stock position is $30,000, we can sell up to 12 contracts of NCM July $24 puts. However, as this is a very volatile stock which is still trending down, we may prefer to have a smaller exposure so we will only sell 10 contracts instead. This means that I am making a commitment to buy 1000 (10 contracts x 100 shares per contract) shares of NCM at $24 per share, and I need to set aside $24,000 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 two months while waiting for the puts to expire. I will receive $1240 ($1.24 x 1000 shares) for making this commitment.

My primary exit for this trade is for my put options to expire worthless. This would be the case if NCM’s share price is above $24 (which is what I expect) when the options expire in July. This means I simply get to keep the $1240 of premium income which is a 5.17% return in two and a half months or an annualised return of 24.18%. As you can see, option premiums are very high when there is strong volatility.

My secondary exit for this trade is for my put options to get exercised so I will have to buy NCM shares. This would be the case if NCM stays below $24 when the put options expire on July 26. Although the dividend yield for NCM is quite low at only 1%, the option premiums we can get for selling options on this type of volatile stocks can be very high. If we own the stocks we should be able to sell a few covered calls to generate extra income to help us achieve our target return of 15% even without income from dividends.

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.  Today NAB is trading at $24.52 and my put options are now only worth $0.30.  Although the stock is trading at around the same price, the time value of the option has decreased resulting in a lower price option. This put option will expire in a couple of weeks and we will find out soon if we will be buying NAB shares at our strike price of $24.50.

For more information about this trade set up, read my April 11 model portfolio update.

Rio Tinto: RIO July $64.00 PUT

On April 18, I sold to open RIO July $64.00 put options for $2.04 when RIO was trading at $66.08.  Since then RIO shares have gone down in price. Today RIO is trading at $61.37 and my put options are now worth $4.00.

For more information about this trade set up, read my April 18 model portfolio update.

Wesfarmers: WES June $29.50 PUT

On April 24, I sold to open WES June $29.50 put options for $0.59 when WES was trading at $29.64.  Since then WES shares have gone up in price. Today WES is trading at $30.12 and my put options are now worth $0.40.

For more information about this trade set up, read my April 25 model portfolio update.

Current Open Position Snapshot

I will be providing a weekly update on 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.

Stay tuned!

Disclaimer: This post is for educational purposes 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 readers interested in this strategy should do their own research and seek investment advice if required.

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