Investiv Daily Sunday Edition

[Sunday Edition: How Bad IS the Worst-Case Scenario?]( By Thomas Moore on April 9, 2017 there is any single issue that generates more uncertainty, anxiety, and questions than any other about the [Rebel Income]( system, I think it may be the perceived downside that comes with a stock assignment. Some of that uncertainty is a good thing, because it is true that selling put options (considered a naked transaction by brokers) without an understanding of the potential consequences leaves you more exposed to risk. However, I also believe that most of the fear that people tend to have about put selling is misinformed. The objective of this article is to try to address some of the popular misconceptions about put selling and give you a more complete understanding of why even the “worst-case scenario” brokers want you to fear doesn’t have to be as bad as it seems. Disclaimer: Today’s post is a long one, because there is a lot of information to cover. I think it is well worth your while, however, so please bear with me and be patient! Misconception #1: Stock Assignments Should Be Avoided When you sell a put, you are selling the put buyer the right to sell the underlying stock back to you at the put option’s strike price. As of right now, stock in Apple Inc. is trading at nearly $140 per share. Let’s suppose that you sell a put option on Apple with a $135 strike price. The premium you bring in for the sale is $3 per share. In exchange for the $300 per contract you’ll bring in to your account, the put buyer will have the ability to exercise the put option at any point up to expiration and sell the stock to you for $135 per share. The only reason the put buyer would want to exercise the put option is if the stock drops below $135. As long as the stock remains above $135 through the option’s expiration date, the contract will expire worthless. The put buyer will lose money on the trade, but as the seller, all of the $300 you brought in when you sold the option is kept as pure profit. This is considered an ideal result, and since the stock was around $140 when you sold the put option, the odds for this result were strongly in your favor. What if the stock is below $135 on or before the expiration date? This is where the put buyer can exercise her right to sell the stock back to you. All they have to do on their side is to buy the stock at the current market price, then tell their broker to exercise the put option. That will require you to buy an equivalent number of shares to the number of contracts you sold. As long as the trade remains open in your account, this is an obligation that you must fulfill. The perception among most traders, which I believe is driven by the directional bias that naturally comes with traditional buy-and-hold investing strategies, is that a stock assignment is a negative action. If a stock drops quickly below the strike price of an open put sale, I’ll often see people start to panic and start asking what they need to do to unwind their trade to avoid the assignment. If you’re selling put options on stocks blindly, simply because the premiums on the put options were nice and fat when you placed the trade, that might be the right course of action. That is not, however the way the [Rebel Income]( system is built. You should notice that whenever I highlight a stock for a put sale, I always mention the fact that if the stock is below my strike price at expiration I will accept the assignment for those shares. I don’t avoid stock assignments because I use put selling as just one part of my overall income generation system. I like to think of put selling as a gateway to ownership of stocks that I would like to own anyway. Selling the put option instead of owning the stock outright is a way to generate immediate, useful income and lower my potential cost in the stock if I am assigned. Let’s go back to our example trade on Apple. If you are assigned the stock at $135, your actual cost is $132, because the put buyer gave you $3 to open the trade. That means that even though $135 may have been a great price to buy AAPL at, selling the put option first helped you get an even better price than you could have gotten by buying the stock outright. Misconception #2: Severe Drops Are Bad & Should Be Avoided At All Costs It’s also important to note that I try to minimize the “worst-case scenario” risk even further by focusing on a stock’s fundamental strength and value proposition. If a company’s business is healthy, and I can make a strong case that the stock’s price should be higher than it is now, the chances the stock will experience a severe drop in price, either during the put sale period, or following a stock assignment should be manageable. Note that I’m not saying it won’t happen; it does happen from time to time. The real question is, how often does this happen? Another question that naturally follows is, how do I protect myself when it does? I want to answer both of these questions by looking at some of the most dramatic examples from my own trades since we began the [Rebel Income]( service. Worst-Case Scenario #1: Joy Global Inc. ([JOY]( Over the course of 17 months from February 2015 to late July 2016, I placed a total of eleven trades (options and stock) related to [JOY](. When I placed my first put sale in February 2015, the stock was trading around $45. Following an assignment on the stock at $40 in May of that year, I watched the stock drop all the way to a low at nearly $8 per share in January – a drop of 80% from my original purchase price. Directionally-biased strategies would have called me crazy for holding the stock once the stock dropped below $30, and honestly I saw a lot of emails asking why I hadn’t closed my position. My reasoning was simple; since the company’s core fundamentals, in particular their free cash flow and debt levels remained healthy, I could attribute most of the decline to external market forces, in particular a broad-based decline in commodities prices like oil and coal. JOY wasn’t losing market share, or facing internal problems associated with poor management, and so I believed that once those commodities began to stabilize, there was a good argument to be made to see the stock drive back to some of its previous highs, which were well above my $40 assignment price. The company’s underlying fundamental strength was healthy enough, in fact that when I saw the stock price begin to recover and show some stability in the $15 – $18 range in the fall of 2015, I decided to take advantage. I placed three new put selling trades and was assigned once more, at $18 per share. Since I was careful to sell a proportional number of contracts on each of those trades to the number of shares I already owned, I was able to average the cost of all of my stock assignments on JOY to $29 per share. After the stock finally found its bottom in the beginning of 2016, it slowly began to climb closer to that $29 price, reaching as high as $24 in early July and making me hopeful the stock would in fact get above my average cost. On July 21, 2015, the stock gapped higher to a little above $28 overnight. JOY had accepted a takeover bid from Japanese competitor Komatsu at $28; this is a deal that as of this writing/recording has yet to close. A week later, and after analyzing the details of the proposed takeover, I concluded that the stock would have little reason to drive higher than the $28 takeover price, which then begged the question: should I wait for the deal to finalize and hope my new stake in Komatsu would move even higher, or should I call enough and finally close my position? I ran the numbers for all of the trades I used to establish my position to see exactly where I stood. Keep in mind that the 6.59% return I’ve shown from all premiums is based on my $29 average assignment price. When I applied those premiums against that average cost, my net cost dropped even more, to the point that the position was positive. Realizing that I was sitting in a net profitable position – even if it was only a small gain – really helped simplify the decision I needed to make. It’s true that a 2.95% net gain over 14 months isn’t all that attractive in and of itself; but since the position was actually positive, and with very limited further upside in the foreseeable future, I decided to simply close the position and move on. My position on JOY is a great example of what can be done to manage a position successfully even when the stock experiences a major drop in price, but the underlying fundamentals and overall value potential remains high. Selling more put options gave me the ability to acquire more shares to average my price lower, and even though two of those trades expired worthless, I was able to use the premiums from those sales against that average and lower my cost a bit more. This position is also a good example of when to decide that it’s time to cut the cord and move on. If you find reliable information that indicates that the stock’s intrinsic value potential is not what you thought it was originally, then in most cases you’ll be better off closing the position, freeing up the capital that was being used, and moving on to something else – even if you close at a loss. Worst-Case Scenario #2: Halliburton Co. ([HAL]( Another “risk” that people are afraid of with put selling is the possibility the stock could drop significantly below your put option’s strike price before expiration. Not only will you be assigned at a higher price, but you will also immediately find yourself looking at a big unrealized loss as soon as the option expires. [HAL]( is a stock that was among my earliest put selling trades, and which did exactly that; I sold my first put in November of 2014 and was assigned at the end of that month at $51. The stock had already started a downward trend, retreating from a July 2014 high at around $74 per share to about $53 when I sold the put. When I was assigned, the stock’s decline had picked up speed, and the stock closed that day at $42.20. Bam – right off the bat, I was down almost $10 per share! Of course, I was aware of the stock’s drop, since its downward momentum had begun accelerating shortly after I sold the put. I held onto the position, however, and accepted the assignment at $51 because my analysis confirmed my conclusion that the stock should be worth significantly more than my assignment price. I decided to be patient and wait, and take advantage of opportunities to sell covered calls if the conditions seemed right and the odds of an ideal result for the trade were strongly in my favor. HAL was a true exercise in patience; after briefly rising to about $47 in May of 2015, I watched it resume its downward trend and drop to as low as $28 in January of 2016. It finally found bottom at that point and began to rally. In December of 2016 (more than two years after my first assignment), it finally rose above my $51 assignment price, which opened the opportunity for me to close the position at a profit. Here’s what the position looked like in the final analysis. My first covered call probably looks a little strange, because I sold a strike price significantly lower than my assignment price; generally speaking, I don’t want to risk getting called out of a position at a lower price than my assignment price, and so if the stock is significantly below that level, my normal policy is to simply hold the stock rather than selling a covered call. I made an exception in this case because the stock’s price was in free-fall, and overall market sentiment around anything oil and energy-related was so bearish at that time that I felt confident the stock would remain below the $42.50 price I sold. This was an extremely rare case of a low-risk covered call below my assignment price. It isn’t a practice I recommend and I call myself lucky more than good to have been able to get away with it. The total profit for this trade is quite a bit more attractive than the result for JOY was, but the key to the patience I chose to exercise really boiled down to the company’s underlying fundamental strength, which remained healthy throughout, and the value proposition for HAL, which also remained well above my assignment price. Worst-Case Scenario #3: Chicago Bridge & Iron NV ([CBI]( While the last two examples are on stocks that I have since been able to close at a net gain, [CBI]( is a currently open position. CBI was a star performer from January through August 2015, as I used five put sales, one stock assignment, and two covered calls to bring in a net 18.79% gain on committed capital over a roughly seven-month period. And while it’s true that a simple buy-and-hold method on CBI would have netted a little over 36% over the same time frame, as an income investor I’ll never feel bad about an 18% gain over seven months. On August 12, two days after being called out of a covered call to close my position on CBI, I sold another put option with a $50 strike price. Only a few days later the stock began dropping, and I was assigned at $50. The stock found a temporary bottom around $32 in February and by late April had risen back up into the $40 range. At that point I sold another put option at $40, which I was also assigned. The stock then resumed its long-term downward trend and didn’t find a new bottom until last fall, when the stock formed a clear double bottom around $28 per share. I sold another put option in late September with a strike price of $26 that expired worthless. From that point the stock has begun an intermediate upward trend, but has only rallied to about $33 as of this writing. Here’s how the position looks right now. Looking at a 22% unrealized loss on a stock I’ve been holding for more than a year and a half is admittedly not a pleasant thing; but it’s important to remember that the loss is unrealized (on paper only) unless I sell at a lower price than I bought. In the same way as I did with HAL, I’ve chosen to hold the stock because the underlying fundamentals remain solid, and the long-term prospects for one of the biggest infrastructure builders in the U.S. should be poised to see a big boost if the infrastructure spending plan promised by the Trump administration materializes. If the stock’s current upward trend fails and the stock drops back below $30, there could be a good opportunity to sell another put option to possibly average my cost lower again or at least apply another premium against my net cost. The company has maintained its dividend throughout as well, and its conservative payout ratio is another indication of CBI’s solid financial position. Another element that works in this position’s favor, and that I can use to counterbalance the current unrealized loss is the profitability of all of the trades I placed from January to August 2015. That leaves me looking a total net unrealized loss on the stock of just a little over 4% since January 2015, which makes it that much easier to keep the stock’s long-term prospects in perspective. Worst-Case Scenario #4: Signet Jewelers Limited ([SIG]( [SIG]( is the most recent stock I’ve acquired and that is significantly below my assignment price. I sold a put against the stock in late August 2016 while the stock was climbing from a trend low, reaching a high point around $95 per share. The day after selling my put, the stock gapped lower by more than $10 per share and pushing the stock to a new trend low at around $73. I accepted the assignment at $90 in mid-September because I judged the stock’s steep drop to be an overreaction to a disappointing earnings report. Indeed, the stock actually rebounded nicely from a double-bottom support test around $73 to revisit the mid-$90 price range in November and December 2016; that gave me the opportunity to sell two covered calls against the stock with a $95 strike price and lower my net cost while adding some nice income to my account. From that point, however, the stock’s long-term downward trend came back into play, pushing the stock back to test its previous support around $73. This week, the stock gapped lower again to drop below $64 on an inflammatory news report alleging gender discrimination and sexual harassment from arbitration claims that were filed against the company in 2008. Suffice it to say that I’m taking the news with a grain of salt and will wait for the stock’s earnings report next week before making a decision on my next move. Here’s what the position looks like as of this writing. As with CBI, it isn’t fun to be sitting on a stock that is significantly below the price you bought it at, and the emotional reality is that when I look at the position each day, I naturally compare the stock’s current price to the price I was assigned at. I have to remind myself that my net cost is much lower than that because of the premiums I’ve been able to bring in so far; but that also helps me keep the latest drop in the right kind of perspective as a value-oriented investor. The stock should see strong support around its current level, or possibly closer to $60 per share. A good earnings report could give the market a reason to use this price to stabilize the stock’s latest drop, and that may open up a good opportunity to generate some more income, and possibly acquire some more shares to average my cost down more. The fundamentals remain solid, and I believe the value proposition is still much higher than the price I was assigned at, and so I am still willing to hold on and wait to see how things play out. Worst-Case Scenario #5: 3D Systems Corp. ([DDD]( This wouldn’t be a very truthful evaluation of the [Rebel Income]( system’s potential risk if it didn’t include an example of an actual losing trade. It is also true that because of the things I outlined in the previous four examples, I’ve been able to limit the total number of losing trades the system has incurred to this one stock. This is a company that came across my radar in the early month’s of this blog’s birth. The fact is that when I began working this stock in August of 2014, not all of the fundamental and value criteria I now use to screen for trades was being used. For example, dividend-paying stocks were not part of my screening process; if it were, this stock would have immediately been discarded since the company has never paid a dividend. I admit that in this case, my head was turned by the cool technology that spoke to my inner geek. I used improving fundamentals including newly positive cash flow as the primary justifiers for the trade because I really like the idea of 3D printing. Here’s how the trade worked out. The reason I decided to close this position at a loss, rather than trying to ride it out as I was able to do with JOY and HAL, and am still doing with CBI and SIG, is because I found new information that changed my perspective about the stock’s core fundamental strength and actual worth. Two weeks before their November earnings report, the company revealed manufacturing problems that would result in production delays that would extend for at least the next two quarters and significantly impact the company’s ability to deliver on their increasing order numbers. It proved to be just the tip of the iceberg as the stock declined to as low as $8 per share and as of this writing has only increased to a little over $15. The stock’s fundamentals have not improved, with a very low Free Cash Flow Yield and unremarkable ROE and ROA numbers that I don’t believe can be offset by the company’s low debt levels or improved stated earnings for the past year. Of course, all of this is moot since the absence of a dividend automatically excludes the stock from my screening. As a result of this trade, we decided to require more stringent fundamental criteria than we had previously, and which helped me define the process I now follow more precisely. Since I closed the position at a loss, it also provided a great case study for how bad a worst-case can actually be, and how that risk can be managed more effectively. When I finally liquidated my shares at $36.96, I owned 600 shares of DDD, which I purchased for an average cost of $50.75. The total drawdown on my account from that sale was $8,274, or 27% of the $30,400 I originally paid for my shares. At the time I acquired my shares at $51.50, my account balance was a little over $120,00, which means my $30,400 position was 25% of that amount. That is a very large position size on a cash-secured account, and 12.5% on a margin account is also larger than I prefer and I have written about on repeated occasion. This was a very aggressive trade; but even so, the $8,274 loss still translated to a drawdown of only 6.65% on the total account balance. Even so, I realized that was a larger loss than I wanted to absorb on any negative trade, and so I also began implementing more conservative rules around the position sizes I wanted to work with. If I had been conservative from the beginning of the trade, I would have purchased only 200 shares by selling only two contracts to initiate the position. That would have taken up a little over $10,000, or 8.3% of my total account on a cash-secured basis or 4.15% for margin – both of which fit comfortably within my current rules. It also would have limited the total size of my loss to $2,758, or only 2.21% of the total account balance of $124,401. It would still have gone down as a negative trade, but with a much, much smaller loss that would have been far easier to recover from. Looking back, I’m glad I have this trade on my [Track Record]( because it is both an excellent example of what not to do and the trade that marked a major turning point in the development, and long-term success of the [Rebel Income]( trading system. Putting Things In Perspective I’ve intentionally provided the most dramatic examples of trades that have gone against me over the last three years for a couple of reasons. First, I want to acknowledge that no matter how thorough my fundamental analysis is, or how excellent I believe a stock’s value proposition is, there is simply no way to guarantee the stock won’t drop below my assignment price – in fact, I expect it to happen from time to time. This is a reality that you can either shrink from or embrace. I choose to embrace it, because as I think I’ve demonstrated with JOY and CBI, those drops can provide good opportunities to add to the initial position (on a conservative basis) at lower prices in order to leverage the stock’s value proposition even further. It’s also important not to dismiss or ignore the value of dividends received while you hold a stock you’ve been assigned from a put sale. Here are the dividends paid by each of the four stocks (not including DDD) I’ve discussed today. - JOY: Four dividends, $.23 per share total - HAL: Seven dividends, $1.26 per share total - CBI: Nine dividends, $.63 per share total - SIG: Two dividends, $.52 per share total The truth is that these dividends, by themselves will probably not constitute enough income to mean nearly as much as the income from put sales and covered calls will; but I believe in the concept that “every bit helps,” and the fact is this is passive money that you don’t have to do anything for except hold onto your shares. Large or small, if a company wants to pay you for being a shareholder, why not take them up on it? It’s also useful to note that these dividends can also be applied to lower your net cost; again, even if the deduction is small, even a little bit helps! Finally, I want to frame these five “worst-case scenario” trades in the context of the entire period since I started publishing this blog. Over that period, I’ve placed 149 put selling trades, and been assigned 40 times. That means that for every four trades I place, I can expect to be assigned once. Of those 40 assignments, I’ve experienced 5 occasions where the stock dropped significantly below the price I bought the stock at. I can expect, then that for roughly every 8 stocks I buy, one will see such a severe drop. And while I can’t guarantee that I won’t end up having to absorb a loss at some point on one or more of those cases, I am encouraged by the fact the stocks I’ve been working with since my DDD trade (using far more stringent and conservative rules and criteria) have provided me with good opportunities to manage the position in a way that ultimately helps me minimize risk, and in many cases avoid loss altogether. The truth is that the “worst case scenario” most people are afraid of when it comes to put selling really doesn’t have to be very scary after all! 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