Options Update: March 2018 (Part 2)

Part 1 of my monthly options update article covered the usual options trades I executed in March.

There is one unusual trade I made that is the topic of Part 2. It is a combination trade with a short put and a long call. The combo trade is net credit and uses LEAPs (long-term equity anticipation securities) to give me exposure to long-term price changes.

I added options trading to DivGro in June 2016 to leverage the equity in my portfolio and to generate more income. The options income allows me to buy more dividend growth stocks and so generate extra dividend income.

Combining dividend growth investing with options trading creates a nice "ecosystem". My portfolio produces dividend income and serves as collateral for a margin account that allows options trading. In turn, options trading produces options income that flows back into my account, allowing me to buy more dividend growth stocks.

Some Background

I started investing in the stock market in 2002, long before I settled on dividend growth investing as my primary strategy in 2013.

I learn best by doing, so I opened a brokerage account with an initial deposit of $10,000, subscribed to a newsletter on investing in blue-chip growth stocks, and bought stocks based on the newsletter's advice.

While following a reputable newsletter was useful and profitable, I found the monthly essays most valuable. They provided a good overview of market conditions and included a stock analysis of the latest recommendation, allowing me to slowly learn the "tricks" of the trade.

With options trading, I'm following a similar approach. I've subscribed to several advisory services, and I'm slowly learning the "tricks" of the trade. Rather than following the trade recommendations, I mostly read them for the purpose of learning.

Two of these subscriptions focus on covered call and put selling strategies. This is what I do, too, though I mostly limit the underlying stocks to dividend growth stocks. Frequently, a recommendation from one of these advisories would cover a dividend growth stock, and if I like the trade, I will execute it. However, most of the options trades I execute for DivGro are ones I developed myself.

I also follow a couple of advisories with more advanced options trading strategies. These are fun to read, and I'm fascinated by the wide array of options trading strategies out there. I'm learning slowly, but, for the most part, the learning is theoretical as I'm not yet comfortable executing these advanced strategies or developing such trades myself.

A New Trade

In March, I executed a trade based on the recommendation of one of my advanced options trading advisories.

The trade delivers 18% up front on margin and has a chance of returning 100% or more (on margin) over the next two years. Here is the trade:

#161	2018-03-14	:	-2	×	KMB 17 Jan 2020 $100.00 P	$    1,503.00	( $       0.00 )
#160	2018-03-14	:	2	×	KMB 17 Jan 2020 $135.00 C	$           0.00	( $  -783.00 )

Kimberly-Clark (KMB) manufactures a range of personal care, consumer tissue, and professional products using advanced technologies in natural and synthetic fibers, non-wovens, and absorbency. Key brands include Huggies, Kleenex, Scott, Cottonelle, and On-Q. The company sells its products directly to retail outlets and through e-commerce. KMB was founded in 1872 and is headquartered in Dallas, Texas.

KBM is in the Consumer Staples sector, which tends to have stable, non-cyclical businesses even in uncertain times. But since June 2016, the Consumer Staples sector has fallen out of favor as investors looked to ride the wave of high-growth stocks.

In February the stock market corrected and volatility spiked. With the bull market getting long in the teeth, there is a possibility that investors would start to migrate to more defensive positions. If that happens, Consumer Staples stocks will benefit and stocks like KMB should recover.

With KMB down 26% from its 52-week high, the implied volatility of long-dated puts is relatively high. The trade takes advantage of this higher implied volatility by selling expensive puts and buying calls that add upside potential in case KMB performs really well over the next two years.

I sold 2 $100 puts dated 17 January 2020 for $1,503 and bought 2 $135 calls with the same expiration date, for $783 per share. The puts will require $20,000 if exercised, so the margin requirement is $4,000. The net credit of $720 is 18% of margin.

Here are the possible outcomes of the trade:

1. KMB trades for less than $100 per share. The $135 calls expire worthless. The $100 puts are in the money and would be exercised, meaning I'll buy KMB for $100 per share. When accounting for the net credit of $3.60 per share, my cost basis would be $96.40 per share. 
2. KMB trades between $100 and $135 per share. In this case, both options will expire worthless, and I would keep the $3.60 per share premium, or $720, which is a 18% return on margin in about 22 months. 
3. KMB trades for more than $135 per share. This outcome is the best case scenario. The higher KMB goes above $135 per share, the higher my returns will be. For example, if KMB rises to $150 per share, the calls would be worth $15 per share, or $18.60 per share when adding the net options premium. That's a return of 93% on margin. 

Concluding Remarks

This trade has a duration of 22 months. If KMB drops well below $100 per share, the puts probably will be exercised. If that happens, I'll own 200 shares of KMB at a cost basis of $96.40 per share. Given KMB's current annualized dividend of $4.00, my yield on cost would be 4.15%.

Otherwise, I'll earn about 10% per year on margin (18% in 22 months).

Thanks for reading! Let me know what you think of this trade by commenting below...