Is is time to rethink your income investing strategies?
I get quite a few emails from options sellers; here’s one of the most common: “The premiums on this stock look great. What do you think of the company?”
That’s what I call “premium chasing,” and it’s one of the biggest mistakes you can make as an income trader.
There’s an inherent tension when selling options for long-term income… The volatility that drives premiums up is the exact same volatility that can negatively impact your portfolio value.
What’s a trader to do?
Start by choosing the perfect income stock.
Choosing the perfect income stock starts with choosing the perfect company. Then you simply need to find the right options to sell. In other words, THIS is question traders should ask: “The company looks great… What do you think of the premiums?”
The Perfect Stock
For the typical income investor, the search for the “perfect stock” begins with a high dividend yield. The average annual yield of a stock in the S&P 500 is only around 2%, which is very low by historical standards.
But high dividend yields may be unsustainable or can be a sign that a company is in distress.
Selling options for income, on the other hand, can generate significantly higher income. For instance, it’s completely reasonable to expect a 25% annual return from selling options, even if the underlying stock goes nowhere.
And like I said before, it all starts with a great company. Here’s what to look for…
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Picking Great Companies
A great company delivers above-average growth based on Wall Street’s preferred measures. Example: The Street’s crucial metric for Netflix (NASDAQ:NFLX) is subscriber growth, NOT the company’s bottom line.
A great company has a unique or dominant position in the market; it’s the idea of an economic moat. Having one makes the stock more resilient—and that’s exactly what you want in a long-term income pick.
Need another solid example? Look at Apple (NASDAQ:AAPL). It’s the clear leader in smartphones, tablets, apps and music. And while it’s no longer a growth stock, Apple is one of my favorite income stocks.
Finally, a great company needs strong management.
I look for a stock that’s undervalued. You can gauge value by using the P/E ratio, the PEG ratio or other metrics. Whichever you use, the key is to see where a stock stands in relation to its sector and the market as a whole, as well as compared to the stock’s historical multiples.
American Airlines (NASDAQ:AAL) illustrates this point. It has a trailing P/E of 4.6. This is less than half of the industry multiple of 9.8 and a more than 75% discount to the S&P 500.
AAL is also trading at a roughly 30% discount to its five-year average P/E. That’s despite strong Q4 results, which included a 1.3% increase in total revenue per available seat miles (a key metric in the airline industry). This is the exact type of anomaly I seek when searching for the perfect income stock.
Before I get into nitty-gritty details about selecting and selling options, I want to share my favorite income stock…
I’ve recommended selling options on this best-in-class oil refiner many times since 2011. In 2016 alone, we traded Tesoro (NYSE:TSO) 10 times, generating $1,576 by selling puts and calls with just three contracts each time.
Tesoro has the lowest operating margins of any independent U.S. refiner, thanks in large part to the proximity of its refineries to shale oil fields, which reduces input costs. And if you didn’t already guess, operating margins are a key Wall Street metric in this industry.
The company also owns most of Tesoro Logistics (NYSE:TLLP), which provides transportation, pipeline and related services to oil companies in the shale fields in the upper Midwest. Tesoro Logistics provides diversification and the potential for long-term double-digit earnings growth.
Finally, Tesoro’s management is excellent and financial reporting is transparent.
With a P/E ratio of 13.7, TSO is trading at a premium to its five-year average of 11.5, but it’s trading at a 45% discount to the industry average and a more than 30% discount to the broader market.
Now let’s get to the juicy details: how to generate income on this perfect stock.
Here’s a quick checklist for Tesoro… Great company: check. Undervalued stock: check. Options: CHECK.
I sell options to generate income, primarily looking for liquid option chains and rich premiums.
When assessing liquidity, open interest is more important than daily volume—but the bid/ask spread is the ultimate measure of liquidity. Just like with stocks, the tighter the bid/ask spread, the more liquid the options.
For premiums, I recommend targeting options that return at least 0.5% per week…
With TSO trading around $97.50, the August $95 strike offers about $1.55 per share ($155 per contract).
Selling that put would deliver 1.6% in less then 30 days ($155 divided by the $9,500 it would take to purchase the shares if assigned, because I only sell cash-secured puts, NEVER naked puts). This exceeds the 0.5% monthly income goal and works out to a 20% annualized return.
Looking to buy TSO shares and sell a covered call instead? The August $97.50 strike has a premium of $2.38 per share ($238 per contract). That would deliver a 2.5% return in 29 days ($2.38 divided by the current share price of $97) and a 29% annualized return.
About The Author
Michael Shulman is a 30 Year Veteran of the financial markets – as a trader, a financial analyst, a financial writer and most recently as an educator.
Mr. Shulman made his first option trade in 1985 – COMPAQ Computer calls – a position that expired worthless. His second trade broke even; the third brought him a year’s salary, a near twenty to one return on his investment. He has never looked back. He entered the financial publishing business formally in 2001 as director of research for ChangeWave Research’s institutional research business and as the writer and editor of Hedge Fund Investing.
He has published two books – Sell Short and Made in America – both of which can be found on Amazon.com, and he is a frequent contributor to reputable financial sites like Seeking Alpha, MSN, MainStreetInvestor, and Traders Reserve.
Most importantly, since 2010, he has dedicated himself to teaching income investors how to get more income from their portfolios using simple yet safe options selling strategies which produce income every week. This approach was developed from the ground up in Mr. Shulman’s own accounts, his goal to develop a strategy that cannot be replicated by institutional investors of any size and therefore independent of fads and trends that change too often to provide a consistent approach for individual traders.
His trade recommendations in his Options Income Blueprint, Perpetual Income Portfolio Club and Income Masters services maintain a 98% success ratio, meaning his trades produce the expected income 98% of the time. No one’s perfect.