The Money Tree

Safely Generating Income in Retirement

Deep OTM NP Strategy – NOV Week 3

Posted by mounddweller on October 30, 2011

Fellow Traders,

The big move up this past week significantly reduced the number of opportunities from which to select our trades.  After filtering out stocks selected last week, and the usual biotechs and small cap Chinese stocks we were left with 21 possibilities.  From these I found two that I would like to highlight for you today.

First up is The Williams Companies (WMB).  The Williams Companies, Inc., through its subsidiaries, engages in finding,
producing, gathering, processing, and transporting natural gas primarily in the United States.

I did a ‘double take’ when I first came across this possible trade.  It seemed too good to be true.  Friday, the stock closed at $31.25.  It has risen sharply over the past month, having been as low as $23.35 when the market bottomed out on October 3rd.  The strike price selected is $20.  That’s why I did the ‘double take’.  It isn’t often you are presented with the opportunity to earn 0.75% ROIC on a trade with 3 weeks remaining to expiration and 36.48% DSP.  However, bells from the school of hard-knocks also began ringing.  Mr. Market very rarely misprices options.  For the premium to be this high there must be a significant amount of perceived risk that WMB could fall substantially in the next three weeks.  However, I found nothing ominous lurking in recent news headlines.  WMB will announce earnings between now and expiration so that could explain part of the premium but it doesn’t seem like it could or should account for all of it.

The $20 strike price is below the 52-wk low of $20.91.  As you can see in the 1-year chart presented below, WMB hasn’t been down around $20 in quite a while.

The 5-year chart is a little more illuminating.  With it you can see WMB has been much lower than $20 in the past 5 years.  However, it also shows WMB is a consistent payer of steadily rising dividends.  That is the primary reason I like this trade.  Over the past 5 years they have more than doubled their quarterly dividend payout from $0.09 to $0.20.  Thus, I can confidently enter this trade knowing that if the stock takes a tumble and I have WMB put to me at $20 I will have acquired a good stock to hold in my portfolio should I so choose.  Having the stock put to me at $20 would give me a current dividend yield of 4% and an opportunity to participate in continued growth of that dividend.

My second selection this week is McDermott International (MDR).  McDermott International, Inc. operates as an engineering, procurement, construction, and installation company worldwide. The company focuses on designing and executing complex offshore oil and gas projects.

Before I proceed any further I want to make clear that I consider MDR a speculative trade.  It is not one I would want to hold long-term as it does not pay a dividend.  However, I think there is a good opportunity to generate some extra cash flow with this trade.

MDR pre-announced a 3rd quarter earnings shortfall last week.  Mr. Market, not liking surprises, responded accordingly driving the stock down sharply.  Having closed at $14.63 on Wednesday it fell to as low as $9.34 intra-day on Thursday before bouncing back a little and closing at $10.97.  Friday, it closed at $10.86.

Their were two primary issues discussed during the company’s conference call.  One centered around unexpected one-time issues on existing projects that drove up the expenses incurred on those projects during the quarter.   The second issue discussed was the anticipated compression of 2012 margins.  Management indicated they thought this issue would be resolved heading into 2013.

Looking at the 1-year chart will show why I like MDR as a speculative trade.

Now that the bad news is out I think MDR will languish down here around $10-$11 for awhile.  Should we get the much discussed year end market rally it might even creep back up over time.  While you can’t see it in the above chart, which only shows closing prices, MDR actually went as low as $9.34 on Thursday but reclaimed over $1.50 from that low to close at $10.97.  To me that means Mr. Market realized it had over reacted and rebounded accordingly.  People, hearing the bad news, ran for the exits without really considering the longer term impact of what was being said.  All of this selling pressure pushed the stock down further than it should have gone.  Once the initial selling panic was over cooler minds prevailed and stepped in to buy the stock at very dressed prices.  As buyers reentered the market the price recovered.  Thus, I think a bottom is in and it is above our strike price of $9.

At $0.15 bid on the $9 put our ROIC is a robust 1.67% with 3 weeks to expiration and 18.51% of DSP.

Well, that’s all I have for you this week.  Happy Halloween to one and all.  Don’t let the little ghosts and goblins spook you too much tomorrow night.

Regards,

Troy

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