Rolling Down and Out

Please note: The rolling down and out example below is to illustrate an option trade adjustment. It should not be construed as a specific recommendation involving Intel.

Writing a Naked Put On Intel

On 11/18/2009 with Intel (INTC) trading above $20/share, I wrote a single naked put at the $20 strike price with an expiration of December (2009), one month away. In exchange, I received, factoring in commissions, a net premium payment of $47.25.

If INTC was trading below $20/share one month later I would be obligated to purchase 100 shares of the stock for $2020, or $20.20/share (which would include the cost of commissions my broker charges me when an option is assigned to me).

But if the put was assigned to me, the net premium I received would serve to lower my cost basis. The adjusted cost basis if I ended up acquiring the shares would be about $19.73 ($2020 less the $47.25 net premium).

With an annual dividend of $0.56/share, the dividend yield on my 100 shares of INTC, based on my adjusted cost basis, would work out to be 2.84%. And if the stock closed at expiration at $20/share or higher, than I would make $47.25 from a $2000 implied obligation in 31 days. That would work out to be an annualized rate of just under 28%.

Now admittedly, these aren't huge gains in terms of total dollar returns or dividend yield. But I consider INTC to be a high quality company with a great balance sheet, durable competitive advantages, and a long history of dividend payments and dividend growth. And I assumed that this trade was only an opening salvo in a longer campaign to acquire INTC shares.

Rolling Down and Out an In The Money Naked Put

Shortly after I wrote the put, the next day in fact, INTC pulled back below $20/share. The stock fluctuated a bit, crossing back above $20/share in early December before dropping back down below that level for several days in a row around the mid-December period.

On the Wednesday prior to expiration, the stock traded in a range between $19.28 and 19.80, closing at $19.38. Even though there were still a couple of trading days to go before expiration, I didn't want to wait and take the risk that the stock might continue falling.

Now, considering that I really was trying to acquire these shares of INTC (but paying as little as humanly possible), I basically had three choices:

Choice #1 - Do nothing and allow the put to be assigned to me

If INTC was still below $20/share at expiration, this choice would give me that predetermined $19.73 cost basis and 2.84% yield. I didn't like this choice because the stock was already trading below my adjusted cost basis.

Fortunately, there were better choices.

Choice #2 - Rolling Out

I would do this by buying back the December put at the $20 strike price and selling a new put expiring in January at the same strike price. This would generate additional net premium gains since I could sell the January put for more than it would cost to close out the December put. By doing this, perhaps I could knock the eventual cost basis of any acquisition down from $19.73 to something around or even below $19.50.

Choice 2 was superior to Choice 1, but as much as I do like INTC, I'm aware that this is a chip maker after all. While I consider INTC to be a world class business with considerable structural advantages, the stock can still be volatile.

So what would happen if the stock continued to fall? What would happens if it traded down to $17 or $18 by the January expiration?

Choice #3 - Rolling Down and Out

Another choice would be to try to roll down to a lower strike price, but in order to accomplish this and still generate premium or a credit, you typically have to go farther out than one month.

And, in fact, rolling down and out was the route I chose.

On 12/16/09 I bought back the December $20 put (with commissions) for $74.74 and sold an April $19 put for $121.24, netting me a credit of $46.50.

Now, if the stock is trading below $19/share at the April expiration date, and I allowed myself to be assigned without making any additional rolls or adjustments, this is how I would calculate my new adjusted cost basis:

I would take the $1920 I would have pay (which includes my commissions for being assigned the shares) less the total net premium received to date ($47.25 + $46.50, or $93.75) which would then result in a total net investment of $1826.25, or $18.26/share. That would then increase the dividend yield to 3.06%.

Of the three choices, I considered this to be the most conservative primarily because it gave me better total protection to the downside.

Others, however, might disagree. The trade off in this case was that I sacrificed time in the interest of getting a lower strike price. If the stock was in a long term downtrend, however, rolling all the way out to April would only give the stock an extra three months to continue to hurt me.

That's why it's crucial to select the absolute best businesses you can so that you don't find yourself liable for something that becomes a penny stock at the first sign of trouble.

It's also interesting (and illustrative) to note that both puts provided almost identical amounts of premium, but the initial holding period was only one month whereas the rolled position required holding for four months.

Update

So how did this rolling down and out trade work out?

On April 16, 2010, INTC closed at $23.39/share. So the stock not only rebounded but it increased in value considerably. Obviously, the $19 put expired worthless and I "booked" the additional premium.

All said, the original position along with the rolling down and out position netted me a total of $93.75.

Following the April expiration, I refrained from writing any new puts on INTC. At $23.39/share the stock wasn't the value it had been, and besides, in the spring of 2010, I was feeling a considerably apprehensive about the market in general so I scaled back a lot of my put writing activities across the board.

On October 19, 2010, however, with INTC trading back down at $19.06/share, I wrote two November 2010 19 puts for a new net credit (including commissions) of $78.50. I was fortunate in that the stock rebounded again and closed at November expiration at $21.14/share.

Again, I'm not keen on writing any new puts as long as the price remains well above $20/share. And in the meantime, the cumulative premium I've "booked" on these three INTC trades is $172.25.

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