Option pricing and new option trades: KMB, CB & EXC
As the market continues to “melt up,” trying to keep up with it by selling put options against stocks remains a challenge. It’s a “double whammy” – from both option volatility and stock valuations.
Low volatility means reduced option prices and greater temptation to sell close-to-the-money put options in order to collect decent premiums. But stocks aren’t cheap here and, in most cases, aren’t trading at levels close to where I’m interested in owning (or being put) them.
There are ways to adjust, however, and my trades this week reflect this. First, I continue to stay focused on the few stocks that I consider still reasonably priced or, better yet, undervalued.
Second, just as I look to buy stocks that are undervalued, I prefer to sell options that are relatively overvalued – in other words, options that are trading at a higher implied volatility (IV) than others. For a given underlying stock, this means comparing the relative IV of its options over the range of strike prices as well as expiration dates.
Generally, further out-of-the-money options will have higher implied volatilities than at-the-money options, while the IV of options with different times to expiration is more variable. Right now it turns out that near-term options are trading at lower implied volatilities than longer-dated options, as can be seen by the current upward-sloping volatility “term structure” of the VIX (data from the CBOE):
To option traders this suggests an obvious strategy of buying near-term options and selling longer-term options. For me it means that selling longer-term naked put options in the current environment makes sense in two ways – I’m not only able to sell further out-of-the-money options (which are closer to prices I’m willing to pay for the underlying stocks) and still collect reasonable premiums, but I’m likely selling the more “overvalued” options as well.
Adjusted positions:
- Chubb Corp. (CB: 56.45 +1.47%, yld: 2.59%) – On 4/1/10 I rolled out and up the July 45-strike puts I’d sold against CB on 1/21/10 by buying them back (for a profit) and selling some October 50-strike puts for a nice net credit. (I don’t mind the possibility of owning CB in the mid to upper $40s.)
- Exelon Corp. (EXC: 42.22 +1.20%, yld: 5.03%) – On 4/1/10 I rolled out the July 40-strike puts I’d sold against EXC on 1/15/10 by buying them back (for a profit) and selling some October 40-strike puts for a net credit. (This trade will improve my return on the position or my cost basis in EXC if I’m put the stock, which I still wouldn’t mind owning at under $40.)
New positions:
Kimberly-Clark (KMB: 66.18 +0.44%, yld: 2.91%) – On 4/1/10 I sold some January 2011 60-strike LEAPS put options against KMB as the stock dipped on market weakness:
Kimberly-Clark Corp. is the world’s top maker of personal and health care products, with brands that hold the number one or two share position in more than 80 countries worldwide. The company operates in four business segments – personal care, consumer tissue, K-C Professional, and health care. Risk to earnings is the company’s exposure to increased costs of raw materials (wood pulp in this case) and energy, as well as currency fluctuations.
Trading at about $63 and yielding about 4%, its shares reflect a neutral to positive intermediate-term picture. A break below the $57-$59 support levels would suggest a less positive outlook.
From a valuation standpoint KMB appears reasonably valued to perhaps slightly undervalued here, with current fair value estimates ranging from about $50 to over $100. The company is a member of Standard & Poor’s Dividend Aristocrats, and has a long history of dividend increases – the latest being a 10% increase announced this past February.
According to DividendInvestor.com, the company has a five-year dividend growth rate of about 9%, which, if continued, would result in a doubling of the dividend payout within eight years or so. My cost basis if ultimately put the stock would be about $56.40 with a corresponding initial dividend yield of about 4.7%.
