CHRISTMAS PROMOTION
LTOptions at a 33% discount during the Year End Holidays.
Tell me More

Tuesday, July 9, 2019

Does Enhanced Investing avoid high priced stocks?

This article appeared first on enhanced-investing.com
----------------------------------------------------------------------------------------------------

If you look at the Track record this year, you’ll notice that as of this writing (June 2019) no single trade has been made at a strike price of $100 or higher. No short Puts sold at or above that level. No stock assignments either. This begs the question:

Should higher priced stocks be avoided when following an Enhanced Investing Approach?
The answer comes down to concentration of risk.

A while back I wrote a piece about Sector Concentration Risk. In that case it was about having multiple positions in symbols that belong to the same sector and the risks that it poses.

Well, today’s case of only one single stock but highly priced, is even worse than Sector Concentration risk as you have even less diversification: It is a large amount capital invested on a single name.
It must be said however, that this is a problem only for small accounts. If the investor has an account below $50,000 then it probably makes little sense to risk stock assignments at $100, as that would require a $10,000 investment, or 20% of the account in just that single position.

Now, if you have that same $50,000 account, but it is a margin account in the US with 2:1 leverage then you are effectively controlling $100,000 worth of capital. Suddenly a $10,000 assignment is not that bad.

Despite a market that is near all-time highs, there are at the moment some attractive candidates above $100 that I would have no problem playing with a larger account.

MMM

Being 21% below the April 2019 highs, MMM looks like an attractive opportunity for Put selling
MMM is trading at a P/E Ratio of 18.4, significantly below its 5-year average of 23.1. It is rated as 4 stars out of 5 by Morningstar which considers the stock to be around fair value at the moment:

Now, if you go to the Options chain for MMM, you can sell an August 155 Put for $138 credit with 55 days to expiration:

The margin required by the broker is $1,686.59 to place this trade. If by expiration, MMM is above 155, you lock that gain of $138. Which on a margin requirement of $1,686.59 represents an 8.2% Return on Margin (ROM) in just 55 days. That’s equivalent to a 54.3% annualized ROM.


Now, if you make it Cash-secured (you have set aside the total capital requirement in case of an eventual assignment) that is $15,500 set aside. A $138 return on $15,500 capital is 0.9% (in 55 days). That’s an annualized Return on Capital (ROC) of 5.9%. Better than having the money doing nothing. Using a margin account (again 2:1 leverage), it is +11.8% annualized ROC.

This position is perfectly fine. As long as you are willing to hold MMM stock at $155, there’s nothing wrong with it. Except your account size. If you are trading with less than $50,000, this assignment would be just too much risk concentration. Too much of the account suddenly depending on the outcome of one single position.

Summing up, No there is nothing wrong with selling Short Puts on high-priced stocks. The only limitation is capital. I try to avoid high-priced stocks for now simply because a stock assignment would occupy too much of the account. It is about risk management mostly. With a larger account, let’s say above $50,000 I’d have no problem doing it. Even better when controlling twice that amount thanks to the 2:1 leverage offered by taxable/margin accounts with US brokers.



If you enjoyed this content, consider acquiring the Enhanced Investing Course. Where you will learn to properly value companies and adopt strategies that truly minimize your risks while increasing your probabilities of making money. Read more details.


Go to the bottom of this page in order to see the Legal Stuff

No comments:

Post a Comment