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”

It is now quite evident that the global economy is not doing so well and is likely to fall into another recession. The frantic slashing of interest rates by the RBA every month is reminiscent of 2008. Our SMSF was completely in cash from December 2007 and we started using this income strategy in August 2008 because interest rates became so low and we were not happy with the returns we were getting from our cash. When the markets are falling, it is scary to buy stocks but if we look carefully, not every stock is doing badly. In bearish markets, it is better to be defensive and today we will take a look at one of our favourite stocks that survived the last recession well and provided us with a good return using this income strategy.

Trade Transactions This Week

Woolworth: WOW August $26.00 Put

From the chart of WOW below, we can see that the price of WOW has been on an uptrend since November 2011. Unlike the mining stocks, the uptrend line has not been broken even after the strong correction in May. Prices have only pulled back to the 50 day MA.  Based on the Vector Vest valuation, WOW is valued at $29.15 so it is undervalued at the current price of $26.24.

What I like most about defensive stocks like WOW is that they are not as volatile as banking and mining stocks. This is quite obvious when we compare WOW with the ASX 200 over the last 5 years (see chart below). Although I understand and accept that prices of stocks will move up and down, no one likes to see big unrealised losses in their stock portfolio. In a bear market, defensive stocks can even move opposite to the main market trend (as WOW did in 2008) and can help to make your portfolio look a little less red when markets fall :-).

WOW also pays fully franked dividends and has been increasing its dividend payout in the last 3 years as shown in the table below. The final dividend is coming up in a few months and the stock will go ex-dividend in September.

Source: CommSec (click to enlarge)

The option premium for low volatility stocks like WOW is generally quite low as well. With the recent market volatility, the option premiums are a little better. From the option chain below, we can get a premium of $0.65 for an August $26.00 put option, which is just slightly OTM. As our allocation per position is $30,000, we can commit to buying up to 1153 shares ($30,000 / $26) so we will sell 11 put option contracts (1153 shares / 100 shares per contract). We will receive $715 ($0.65 x 1100 shares) of option premium and we need to set aside $28,600 ($26 x 1100 shares) to buy WOW shares, if our put option contracts get exercised.

Source: CommSec (click to enlarge)

My primary exit for this trade is for our put options to expire ITM and for us to be assigned WOW shares at $26.00. This would be the case if WOW’s share price falls below $26.00 when the options expire in August. We will own the shares when WOW goes ex-dividend in September and hopefully collect another $0.65 in dividend income in October, plus another $0.28 of franking credits.

My secondary exit for this trade is for our put options to expire worthless. This will be the case if WOW shares are trading above $26.00. We will simply get to keep the income of $715 from selling the put options which is a 2.5% return in just under 3 months or an annualised return of 10.74%.

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.  RIO shares have fallen even further since last week. Today RIO is trading at $54.23 and our put option is valued at $10.27. Our cost for RIO shares if our puts get exercised is $61.96 ($64 strike price – $2.04 option premium). Although this trade is not doing well, our loss is still less than that of stock investors who simply decided to buy RIO shares at $66 in April.

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.  WES was also affected by the stock market correction but like most stocks from defensive sectors, they tend to fall a lot less compared to stocks from the volatile mining and financial sectors. Today WES is trading at $29.20 and our put options have increased in price to $0.84.

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

Newcrest Mining: NCM July $24 PUT

On May 9, I sold to open NCM July $24 put options for $1.24 when NCM was trading at $24.24. NCM has gone up in price and is trading today at $25.65. Our put options have decreased in price to $0.72.

For more information about this trade set up, read my May 9 model portfolio update.

Iluka Resources: ILU July $13 PUT

On May 16, I sold to open ILU July $13 put options for $0.78 when ILU was trading at $13.07. ILU has fallen in price since and is trading today at $12.45. Our put options have increased in price to $1.19.

For more information about this trade set up, read my May 16 model portfolio update.

National Australia Bank: NAB September $24.01 CALL

On May 30, I sold to open NAB September $24.01 call options for $0.76 when NAB was trading at $23.76. As expected, NAB fell in price after the stock went ex-dividend on May 31. Today NAB is trading at $22.37. Our call options are now worth $0.57.

For more information about this trade set up, read my May 30 model portfolio update.

Current Open Position Snapshot

A summary of our open positions is shown in the table below. We have 5 open put positions and 1 open covered call position.

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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