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How To Determine If Your Stock Is Safe?

“That was amazing. How did you do that?”

I have to pat myself on the back. While most investors have had a stressful week, the readers of the newsletter I publish – The Palm Beach Letter – were able to relax.

The S&P 500 fell 11% from August 3 to August 8. Overall, our portfolio dropped only half as much. And the five recommendations we’ve made in our monthly newsletter lost only 1.8% on average. (Three of them actually gained in value.)

We received many grateful letters from our readers. Some wanted to know how we did it.

In today’s essay, I’m going to show you my technique for picking safe stocks. Don’t be surprised. This technique is incredibly simple. My two tests will take
about 10 seconds each to perform.

If your stock passes these two tests, it’s safer than 99% of all stocks in the world.

The first test I do is open up a chart of the stock and see how it performed in 2008.  The 2008 financial crisis was the worst market crash since the Great
Depression. The S&P 500 declined more than 50% in less than a year. Many riskier stocks fell 90% or more. It was a true massacre.  So if your stock held its value during this crisis – or better yet if it was one of the rare stocks that actually rose – it’s worth evaluating further. It might be a safe haven.

But if the stock tanked in 2008, I won’t touch it. It goes in the trash. A great analogy for this is the car market. A car manufacturer might tell you
its car has airbags, side impact protection, an onboard computer, and anti-lock brakes. But until you’ve driven that car into a wall at 110 miles per hour, you
won’t know it’s safe.

It’s the same with stocks. You might find a great business with an honest CEO and a prudent management team. But until you’ve seen how that business performs in a crisis, you can’t know it’s safe.

A bank in Connecticut called People’s United Financial passed this test. Fast food giant McDonald’s and the mining royalty firm Royal Gold held up as well. There’s also an insurance company from Canada called Fairfax Financial. It rose 36% in 2008.

The second test I do is my debt test. The fact is, if a company doesn’t have debt, there’s no way it can go bankrupt. Any company can go out of business if it
can’t make a profit. But if it doesn’t have debt, it can’t collapse – like Lehman Brothers did.

So the first thing I do is look at a company’s long-term debt. Ideally, I like to see a big fat zero there. Often though, companies have debt, but they have
more cash…

Take a company like Johnson & Johnson, for example. Johnson & Johnson has over $17 billion in debt. But it has over $26 billion in cash. In accounting terminology, Johnson & Johnson has zero “net” debt. I consider these companies safe, too.

The easiest way to run the debt test on a company is to compare its “enterprise value” with its market cap. You’ll find both these statistics on Yahoo Finance’s Key Statistics page.  Enterprise value is market cap plus net debt. So if a company’s enterprise value is less than its market cap, then the company has more cash than debt.  It’s safe. But if its enterprise value is greater than its market cap, then it has debt. It fails the test.

What you’ll find is that a lot of companies have tiny market caps in relation to their enterprise values. If you’d run my test before Lehman Brothers went
bankrupt, you would have seen its enterprise value was 30 times greater than its market cap.

These companies are among the riskiest in the world. They go bankrupt the day Wall Street stops lending them money. (And I’m constantly amazed how many
American companies operate their businesses like this.)

In sum, to figure out if your stock is safe or not, perform my two 10-second tests. First, look at its chart. Did it maintain its value in 2008? Second, look at its enterprise value. Is it less than its market cap?

If you can answer “yes” to these two questions, you have a safe stock in your possession.

 

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When To Take Action with Covered Calls

The basic covered call trader will write a call and wait until it expires then decide what action to take next.  I suggest that you monitor your position and determine what changes to make before expiration to enhance your profit or decrease your downside risk.

For the call writer with less time who does not have the time to monitor the position, you have 2 options to negotiate the market action:

  1. Determine the price you want to close the position and then set an automatic stop order.  For example, you entered a covered call and you do not want to let the stock decline so you enter a stop order to but the sold option at market and then sell the stock with both events triggered by your predetermined stock price.
  2. Let the option go until expiration and then make your next move.  This strategy does not mean you will lose money but you will keep selling calls to minimize any stock price decreases over time.

Now, for the more active covered call trader, here are 2 actions to increase your trading profits:

  1. If the price of any option you sold declines to a small amount, then buy the option back to lock in profits on the option.  If the option price drops to 25 cents per share or less, then you can buy it back with the different between sold option price being a profit.
  2. The second option is to watch the time value of an in-the-money option and buy it back when the time value gets low.  the rationale is that you have made most of the profit already as time value can only go to zero.  If there is only 10 or 20 cents left, you can buy to close and sell another option for more premium income.

There is no right or wrong strategy based on these two methods to trade covered calls.  You should decide if you fall into the first scenario (less monitoring) or the second (more activity) based on your time commitment to your covered call trades.  In a later post, I will discuss my way of trading covered calls based on a strategy that takes option obligation and stock price into consideration.

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Writing Out-Of-The-Money Covered Calls

If you are bullish on a specific stock, then you should consider writing an out-of-the-money (OTC) covered call.  This type of call includes a strike price that is above the current stock price.  You still get a call premium but is generally less than an at-the-money call.  But you also get the potential of stock appreciation because of the higher strike price of the call sold.  This creates a situation for potentially two income streams from one trade.

This trading strategy works best when you can confirm the stock being in an uptrend or if the stock is bouncing off a support level.  A support level would be something like a 50-day moving average or even a Bollinger Band that has been stretched on the bottom.

The key to this strategy is to be right about the stock price moving higher in the near future.  Due to the OTM call offering less premium than an ATM and having a low delta, they can be slow to lose value on a stock pullback.  This strategy should be used in special situations or during a slow moving bull market.

Also, you want to avoid this strategy when he stock has gapped up until the new price range is confirmed.  Stocks that gap up usually pull back before they stabliize in a new trading range.  However, a stock slowing moving up is a good opportunity for OTM writes.

This strategy works well when you have a down-day in the stock or market.  The stock price decline will usually be temporary down and will bounce back in a few trading days.  You need to be sure the market decline is not a permanent correction that will be sustained for months.

This is a good strategy for stocks you do not want called away in a flat market.  You can still get an increased profit if the stock price is above the entry price at expiration.  Then, you get an even bigger return if you get called out at the higher call strike price.

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Income Option Trade for a 12% Return

In our Monthly Income Report, we look for opportunities to utilize option selling to generate consistent income. While we focus on selling cash-secured puts and covered calls on high quality stocks, we sometimes identify high return trades for increased income. These are stocks with positive confirmation and continuing chart trend based on technical analysis. This month we have identified a stock with a bullish technical indicator that has potential to generate a 12% return in only 40 days.

The option trade for monthly income:

Stock: CF Industries Holdings, Inc. (CF) manufactures and distributes nitrogen fertilizer, and other nitrogen products. The Company’s nitrogen fertilizer products are ammonia, granular urea, urea ammonium nitrate solution (UAN) and ammonium nitrate (AN). Its other nitrogen products include diesel exhaust fluid (DEF), urea liquor, nitric acid and aqua ammonia, which are sold primarily to the Company’s industrial customers, and compound fertilizer products (nitrogen, phosphorus and potassium or NPKs). The Company’s segments include ammonia, granular urea, UAN, AN and other.

The stock has pulled back from its February levels due to industry pricing pressures. Revenues are likely to rise 13% in 2017 and 6.9% in 2018, after falling 15% in 2016. We see steady North American fertilizer demand growth in 2017, but some pressure on prices. However, new production is likely to lead to increased volumes for CF in 2017. We think market conditions will start to improve with this earnings release as capacity additions slow and Chinese capacity reductions continue.

This stock has formed a diamond bottom pattern (Bullish), providing a target stock price for the short-term above $30 per share. We think the stock can hit the target price within 6 weeks or less. The price recently displayed stronger RSI and positive PMO movements signaling a new uptrend has been established. The Short-Term KST indicator has triggered a bullish signal by rising above its moving average.

Recent bullish option flow has been detected in CF Industries with 5,006 calls trading, 3x expected, and implied volatility increasing almost 4 points to 41.09%. Aug-17 32.5 calls and Aug-17 30 calls are the most active options, with total volume in those strikes near 2,500 contracts. The Put/Call Ratio is 0.22. Earnings are expected on August 2nd.

Sell PUT Option for Monthly Income

 

 

 

 

 

 

 

Strategy: CF is currently trading at $27.89 per share. We want to sell a cash-secured put option on CF using the August 2017 30 Call. For each 100 shares of CF you want to control, sell one August 30 PUT option for a $3.00 credit or better. That’s potentially a 12.0% assigned return in 40 days.

Exit Trade: Be prepared to exit the PUT (buy to close) when the stock price moves above $30 to lock in profits. If not, there is a chance the stock may be put to investors. If this happens, then investors can sell covered calls for monthly income until the stock is called away.

This is a higher risk trade than we normally place in the Monthly Income Report. However, this is a nice setup with a high volatility play, positive chart technical confirmation and increased premium from selling options for monthly income.

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How to Sell Put Options for Income

Let’s walk through an example of how to sell a put. After careful selection of the right stock, you decide you would like to create a monthly income stream by selling puts each month on this stock. Let’s say the stock is currently trading at $70 in the market. After reviewing the option chain, you decide to sell the 67.5 put option on this stock that expires in one month. The 67.5 strike price is out of the money and will obligate you to buy the stock at $67.50 only if the put buyer decides to exercise the option on or before the expiration date. The put buyer will only exercise the option if they make money or if the stock price is below $67.50.

As the put seller (writer), you get to collect the cash premium for the option. In this case, let’s assume it is $200 per option contract or 100 shares of stock. The investor now has a risk of $67.50 – $200 = $65.50 per option contract sold. If this amount of $6550 per contract is in the investors brokerage account, this is a cash-secured put. The potential return is $200 which the put seller will keep regardless of the trade outcome.

The investors return is calculated as $200/$6550 or 3.05%. This is a nice return on a one month put option. On an annual basis, this is a return of 36.6%! This is why I sell put options for monthly income.

Here are the details of the trade:

1 Option = 100 Shares of Stock: In this example, we sold 1 put option. In other words, we sold someone the right, but not the obligation, to sell 100 shares of stock to us for $67.50 on or before the option’s one-month expiration date (usually the 3rd Friday of the month).

$ 2 = Our Options Premium: In exchange for giving someone (the put buyer) the right to sell us 100 shares of stock at $67.50, we get paid in cold-hard cash! In options lingo, we get paid in the form of a premium. In this example, our premium is $ 2 per share. Because each options contract equals 100 shares of stock, here our premium is $ 200. This $ 200 is deposited in our account at the time of the transactions. It is ours to keep no matter what transpires before expiration (the end of the contract).

There are 2 potential trade outcomes:

  1. The stock prices stays above the 67.5 option strike price so the put option expires worthless. Put yourself in the position of the options holder (the person that buys the put option from us). The put holder purchased the right, but not the obligation, to sell 100 shares of stock at $67.50 per share. Assume this put option expires in one month. If, at the end of that one-month expiration time period, the stock is trading at a price above $67.50, why would the put holder exercise his right to sell the stock at $67.50 when he can sell at a price above $67.50? They would not exercise the put option! The investor keeps the $200 premium and has a 3.05% return in one month.
  2. The stock declines in price and is below the 67.5 option strike price. The option will be exercised and the shares of stock will be sold to us at the strike price ($ 72.50 per share). Again, put yourself in the position of the put holder for a moment. If, at the time the put option is set to expire, the stock is trading at $65, and the put holder has the right to sell shares of stock at $67.50, why wouldn’t the put holder exercise his right to sell the stock at $67.50 per share? They would. So in this scenario, the cash we previously deposited into our brokerage account ($6750) is used to purchase the underlying shares that were “put” or sold to us. Our break-even point, also referred to as our “cost basis,” is now $65.50 ($67.50 per share we paid for the stock less the $ 2 per share put premium we received from the original sale of the put option). At this point, we own 100 shares of stock and can sell them or write a covered call trade.

This is a simple example of how to sell (write) a put option for monthly income. Once we do this each month we create a stream of cash flow to help us achieve financial independence.

Last month, we were successful on all put trades and averaged 3.5% return for the month.  Imagine making $3000 or more in income each month!   Start making more income each month by subscribing to the Monthly Income Plan.

Monthly Income Plan Newsletter

Signup below to receive a free copy of the Monthly Income Plan newsletter for October 2011.  This report contains a market update, list of monthly dividend payers, covered call trades, protective puts and calendar spreads.  Subscribe to Monthly Income Plan.

 


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