This trading strategy is very similar to the Put Option Dividend Strategy, but this strategy can be applied to stocks that don’t pay dividends, which provides some versatility and diversification. It would also keep transaction costs low as opposed to the Put Option Dividend Strategy with Covered Calls Strategy, which requires more options to be sold instead of one long-term option. The ideal situation would be to combine the two approaches into companies that you feel are fundamentally sound, and you will have a market-beating, low risk portfolio of stocks that generate returns greater than or equal to the market.
The stock I would like to use as an example of this strategy is Google (GOOG). While the ability of you or I to purchase 100 shares of Google may be extremely limited because of its current trading price of $452.96 for a total cost of $45,296.00, it does represent a prime example of this type of strategy.
Today (March 9, 2007) we purchased the following position:
Total cost of the position is $45,316
Below is a graph of the possible outcomes from this transaction.
As you can see from the above possible outcomes, this trade is fairly low risk and provides a decent return in the market should Google (GOOG) perform. Should Google reach $540 by January 16, 2009, you would realize the full return from this strategy. The $8,684 provides for a total return of 19.16%, which if annualized to the trade, would mean a total annual return of approximately 10.45%. While the risk for the trade is -.38%, for a risk to return ratio of 1 to 27.5 (meaning we are risking $1 for a potential return of $27.50), giving us a great potential return for relatively no risk.
There is a risk associated with the Time Value of Money, meaning that you are tying your money in this trade for 2 years, when it could have been sitting in a bank account or treasury bill earning 5% per annum in interest. If you take into account a 4% interest rate that you could have been earning in a bank account, you potentially give up approximately $1,812.64 in interest payments a year. The risk to reward ratio then becomes 1 to 2.20 ($1 risk to potentially gain $2.20), which I would consider still a good trade off since the outcome is previously known, unlike investing in individual stocks unhedged where you are risking a lot for hopefully a positive potential payoff.
It is advisable to anyone who might consider this strategy to use it against a portfolio of stocks and preferably alongside the Put Option Dividend with Covered Call strategy because it would create a low risk portfolio that is capable of generating a consistent and predicable return.
This analysis did not take into account taxes or commissions. If you have any questions please feel free to comment below and I will be sure to answer them as soon as possible.
