Today I’m recommending something that is more capital appreciation oriented, with a options income kicker as gravy.  International Business Machines Corporation (IBM) has taken something of a beating recently.  That leaves us a situation where a truly valuable global business is trading at a discount to intrinsic value.  Big Blue has reinvented itself multiple times in the past and I expect another turnaround over the next 8 quarters.  How good is the opportunity?  I’m going to say at a minimum, IBM should trade at a Price to Operating Cash Flow multiple similar to its industry.  (Ordinarily we’d use Free Cash Flow but IBM’s FCF is skewed by aggressive capital spending while it retrenches.)  The industry is trading at a multiple of 11.00 while IBM is trading at a multiple of only 9.30.  That gives us about 18.3% upside before accounting for any growth, dividends, or per share appreciation from IBM’s aggressive share buyback program (about 6% of outstanding shares per year!)

Today’s closing price was 164.83 and we’ll use that as our reference price.  If we adjust this to the industry multiple of 11, we get a share price of 194.96.  We are going to take this as “fair value” and write covered calls at the next strike, 195.

Action to take: Buy IBM at 164.83 and write IBM160115C00195000 for about $2.20.  That is the 15JAN2016 expiry 195 strike call for raptors that don’t speak the lingo.  Over 327 days until expiry, 2.20 in premium versus 164.83 in cost basis gives us an annualized yield of 1.5%.  This doesn’t seem like much, but it is 55% more than simple buy and hold is earning from the 2.7% dividend yield.  Our total gains could be about 30 dollars in capital appreciation, 4.40 in dividends, and 2.20 in options premiums for a maximum annualized return of 24.9%.  More likely, is the call expires worthless, we keep the option premium, the dividends, some share appreciation, and get a roughly 6% bonus in the form of continued share buybacks.  We can then write more covered calls.  I get approximately 19% annualized for front month near the money covered calls on IBM, so we might do quite well over the next couple years.  If growth returns to the company, the gains could be explosive.

Devour your prey, raptors!

Buy to hold Big Blue – write OTM calls

Never miss another opportunity to devour prey!

4 thoughts on “Buy to hold Big Blue – write OTM calls

  • February 25, 2015 at 8:29 pm
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    Really enjoy reading your blog. I have just built up a nice stockpile of Dividend stocks and I am looking to learn more to starting writing puts, like on IBM to generate extra cash. I have 110 shares at 160 . I have my account at Tradeking, I am going to see what is the margin rate for buying puts . Where do I go to learn more about options, any paper trades to learn the trade ? I guess I am just afraid to get started on something new .

    Thanks

    Vish

    Reply
    • February 26, 2015 at 12:20 am
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      Vish,

      I learned about options originally during my MBA classes. That was unfortunately focused on *buying* puts to gain leverage, not for me. I later joined a Motley Fool service “Motley Fool Options” which is focused on selling unleveraged options. I learned a lot and came to the conclusion I could do even better than the Fool was by restricting my options plays to only the biggest and safest companies. Basically, 1) make sure you would happy to own the shares at the strike price (because eventually you will) and 2) don’t use leverage/margin. Especially, as a newcomer to options, you want to play defense. You can make above market returns with lower than market risk. Where people get into trouble is when they let their greed drive their trades. Keep emotion out of it! I’ll email you some documents shortly to help you learn the ropes.

      Reply
  • February 26, 2015 at 7:13 pm
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    Hi FV, very nice analysis. I play the same game with CVX. Bought the stock with 100+ shares and then write covered calls.

    One question: why buy the stock directly? Isn’t it better to write puts at, for example, $160?

    All the best,
    MU

    Reply
  • February 27, 2015 at 2:22 pm
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    MU,

    There is theoretical no difference between the profit/loss profile of writing a put or a covered call given you write at the money. This makes sense because if the premiums get out of balance an arbitrage opportunity exists to make a risk free gain on the out of balance.

    My strategy is to only write options on stocks I already want to own. In the case of IBM, I want to hold it to capture both dividends and some upside appreciation. So I am writing well out of the money covered calls with the expectation that I’m giving up some potential premium income in exchange for long term appreciation.

    Another consideration I have as a blogger is that followers might make a five to one leveraged trade with written puts but writing with the cash to secure the purchase. Even on big slow moving blue-chips, this is at least moderately ill-advised. I don’t want to put the razor in their hands!

    Reply

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