More Lessons from Vegas: It's Good to be the House
Patrick is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Yes, I've been back again (I love my job). This time as I watched the cards and money flow around the poker table, with stacks getting smaller in front of some people and getting larger in front of others, I reflected that good players are like good investors -- they consistently make smart decisions, even if they don't all work out.
Then there's the house. Every hand, they take a couple of dollars from the pot to pay for the dealer, to pay for the facility, to keep the lights on, and to make a tidy profit besides. They profit from their customers' gaming, whether they win or lose.
It's a good business to be in, and I suddenly realized that I run my options trading the same way the casino runs its poker table, with the exception that I get to pick the cards, er ummm, stocks.
I've already discussed my "Good, Bad, and Ugly" style of picking stocks. Now I'll share how I use them like the house does, by facilitating other investors' bets, by selling options.
New to my "good" list this month are Cliffs Natural Resources (NYSE: CLF), Norfolk Southern Corp. (NYSE: NSC), and RPC, Inc. (NYSE: RES). All share good dividends, good profits, and low debt. None of them have participated in the recent stock runup.
Rather than simply buy these underdogs, who might continue to underperform, I had sold puts on them, sold others the right to sell them to me at still lower prices. Whether I ever have to buy the stocks or not, I get to pocket the money for those puts. Couple that with the fact that puts have an expiration date, that people have to buy them over and over, and I have a nice little earning vehicle.
Take Cliffs Natural Resources, for example. A few weeks ago, I sold puts for $2.46/share in exchange for the right to make me buy those shares at $72.50. Should I eventually be made to buy the shares, my effective price will be only $70.04. Cliffs traded today at $70.14, so even though it's hardly the best trade I've ever made, if the option were exercised tomorrow, it would be as if I'd been given a dime discount on a stock I already decided that I liked! If the option is never exercised, I still have my $2.46, for a profit of 3.4% in a month, or 40% a year if I do this month after month!
Sliding to my "bad" list were Qualcomm (NASDAQ: QCOM), Automatic Data Processing (NASDAQ: ADP), and Air Products & Chemicals, Inc. (NYSE: APD). I had covered puts on all of them. Qualcomm and Automatic Data have run up with the market (in Qualcomm's case, done quite a bit better), and so the puts expired worthless and I pocketed the premiums, just as the casino pockets the rake. Air Products slid more or less sideways, and I found myself owning the stock at a discount price.
Now I can play almost the same game with Air Products stock that I did with the cash I used to buy it: I use it to cover the sale of a call option (see Outsourcing the Sell Decision). When the stock was put on me, I sold a call on it, driving the effective buying price down to about $88/share. Today the call and stock have a net value of $89.71/share, which will almost certainly be worth $90 at expiration, a profit of 2.2% over two months, or 13% annualized. Not bad for one of my losers.
Of course, I missed some big gains here, but like the casino I am comfortable letting other people play for the big money while I pocket the rake month after month.
Motley Fool newsletter services recommend Automatic Data Processing. The Motley Fool owns shares of Qualcomm. SlowThought is long Cliffs Natural Resources, Norfolk Southern, and RPC, Inc via covered puts. He is long Air Products & Chemicals via covered call. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.