Illinois Tool Works Stock Option Trade
How can a company like Illinois Tool Works Stock (symbol ITW) aid investors who are seeking better returns than money market rates or certificates of deposit (or in Canada – Guaranteed Investment Certificates) while having some comfort that their hard-earned capital won’t be lost in a stock market meltdown?
Since the end of 2008, the Federal Reserve is penalizing savers. It has become the third year of basically minimal returns for keeping your capital safe. By now savers are realizing that there is little likelihood of a quick return to higher interest rates. With a little work, dividend stocks like Illinois Tool Works Stock can help investors earn a reasonable return and have some semblance of hope their hard-earned capital will not be lost in a market collapse.
I found out years ago that during heightened periods of high volatility, it made a lot of sense to look at big cap dividend payers such as Illinois Tool Works Stock and calculate what sort of return I would like to get through their dividend payments. Since dividend payments are taxed differently than straight interest earned, it makes even more sense to look at dividend stocks.
The biggest problem is that any market meltdown will hit all stocks and result in loss of capital. How should an investor strive for a good dividend return and seek to protect against a downside in the stock. I will use Illinois Tool Works Stock throughout this example, but this strategy could be applied to dozens of large cap dividend paying stocks.
Illinois Tool Works Stock Is A Great Choice
Illinois Tool Works is a diversified company with strong earnings, a decent balance sheet, good future prospects and good management at the helm. You can read more about Illinois Tool Works Stock at their website. The present annual dividend is $1.44. Illinois Tool Works Stock has paid a dividend since 1933 and increased it every year for the past 48 years.
At the time of writing this article, August 25 2011, Illinois Tool Works Stock price is at $43.57. That means with an annual dividend of $1.44 the Illinois Tool Works stock is paying 3.3%. But before getting excited at a 3.3% return, consider how much nicer it would be to earn 4% instead and have some level of protection against a severe decline in Illinois Tool Works stock.
The Steps Guaranteeing 4% For 5 Months Risk In ITW STOCK
The steps I will discuss below for Illinois Tool Works Stock, are the same steps I take with any stock. I present this article so other investors can pick through it and consider developing their own strategies based on the steps I take. If am readers have any suggestions or ideas please post them to the comment section below.
STEP 1: Look At The Closest Bear Market Period For The Stock
Below is the chart for the past 5 years in Illinois Tool Works stock.I have marked the bear market collapse of 2008 to 2009. Illinois Tool Works Stock price reached a low of $25.60 in March 2009.
Lets look closer at Illinois Tool Works stock in that panic period through the chart below.
In October 2008 the market fell apart and continued in that fashion into March 2009 when ITW stock hit a low of $25.60. The problem with a bear market is an investor never knows how low a stock can fall. But at $25.60 the dividend would give a yield of 5.6%. One of the more important aspects is where did ITW stock trade most often during the panic period. Looking at the chart below, it is clear that the strike of $35.00 would certainly be a reasonable price to consider entering Illinois Tool Works Stock.
For interest, or possibly confirmation, let’s look at Illinois Tool Works Stock in the 2001 to 2003 bear market. In that bear ITW Stock fell to a low of around $26.00, which is very close to the $25.60 low of March 2009. The annual dividend in Illinois Tool Works Stock in 2001 was .44 cents. Today ITW Stock is $1.00 higher.
But one of the more important points learned by looking at the past two bear markets is that if I had been assigned shares in Illinois Tool Works Stock at the $35.00 strike I would have been able to sell covered calls and be exercised out of the stock which would leave my capital intact and allow me to earn the dividend as well as the income from both the ITW Stock put and call options sold.
SUMMARY STEP 1:
ITW stock has twice fallen to around $26.00 in a bear market. I have some confidence that in another bear market panic, Illinois Tool Works Stock could fall to that same level but not much lower.
The $35.00 strike is worth considering since the dividend of $1.44 would give a yield of 4.1%. The strike is not only decent for the yield, but just to review, I have confidence based on past bear markets that if Illinois Tool Works Stock falls below $35.00, it will recover and I should be able to sell the stock for a profit sometime either during the bear market or when it ends. Meanwhile I would be earning a superior dividend return.
Overall by examining these past two bear markets I have a lot of confidence in the strike I have chosen for Illinois Tool Works Stock.
STEP 2: Look At The Put Option Premiums For The Stock
The next step for me is to look at put option premiums for Illinois Tool Works Stock. My strike choice is $35.00 which provides me with 4.1% annual return from the dividend and a good opportunity that if the stock falls below my strike, it will recover and I will be able to sell the stock sometime in the future and perhaps for a small capital gain.
At $35.00 I can look at selling the put a number of different ways. I can sell the $35 strike put option one month out at a time, but with the stock at $43.75 the September 17 2011 $35 put strike is .20 cent bid, .25 cent ask, which is not very much income. I could consider this strategy if I could repeat the gain of .20 cents each month for a year, my return on the $35 strike would be $2.40 (.20 x 12) = 6.8% before commissions are taken into account.
The October $35 strike in Illinois Tool Works stock is .65 bid and .75 ask. At .65 the return is 1.8%. If assigned in October I would then sell covered calls for December at $35.00 and I would be eligible for the December dividend payout. That’s not too bad a situation.
But looking at the January $35 strike I see that the bid is $1.50 and the ask $1.60. This provides an immediate return of 4.2% and my cost basis in ITW Stock would be $33.50. If I combine the annual dividend of $1.44, my cost basis in Illinois Tool Works Stock would be reduced to $32.06.
STEP 3: Look At The Covered Call Option Premiums For The Stock
I like to be prepared. If I was assigned ITW Stock on the way down what are the chances I could sell a 6 month or 1 year covered call on the stock? With Illinois Tool Works stock trading today at $43.57, I can get some idea of what covered call premiums might be, by looking out at the present January 2012 and March 2012 call strikes.
To try to get some idea of what 5 months out in calls on Illinois Tool Works Stock would be worth, I consider that with today’s stock at $43.57, it is instead $33.57. Call options just like put options are based on the actual stock, its volatility, time frame, and premium algorithms for that specific stock. This is why stocks with higher volatility such as VISA have a completely different set of premiums, versus Illinois Tool Works Stock.
While this sampling of call premiums is not scientific, nor based on any degrees of accuracy, I have found after 35 years of dealing with options, that this sampling actually does give a pretty good idea about what I could expect.
Therefore the January $45 call then, would be the January $35.00 call. Right now then, I know that the January $35.00 covered call might return around $3.00, 5 or 6 months out from when I could be assigned.
In this same sample if the Illinois Tool Works Stock fell to $25.60 which was the previous bear market low, and I wanted to sell the $35.00 call, I could receive .80 cents for a 5 or 6 month out $35 covered call, based on the call options below. In my chart below the $52.50 would be around the $35.00 strike.
What about going out 7 months? Here are today’s March 2012 call options. The $45 call would be $35.00 and the premium is around $3.50. Again, in this same sample if Illinois Tool Works Stock price fell to $25.60 which was the previous bear market low, and I wanted to sell the $35.00 call, I could receive 1.15 cents for a 7 month out $35 covered call, based on the call options below. The $52.50 in the chart below, would be around the $35.00 strike with the stock at $25.60.
It is also important to remember that should Illinois Tool Works Stock price collapse quickly, volatility will be higher and call premiums may also be higher.
STEP 4: Put In Place The Overall Plan and Execute It
Now that I have the above information, it is easy to put in place my plan. I pick the amount of capital I want to commit to Illinois Tool Works stock. In my example I will pick $35000.00. This will give me 1000 shares of ITW Stock.
I want 4% return for my capital. Therefore I will sell the January 2012 $35 put at $1.50 which immediately returns 4.2% on my capital and I am guaranteed my 4% return. I now have an extra $1500.00 which reduces the amount of my capital needed to $33500.00 and places my cost basis in ITW stock at $33.50.
If I am not assigned shares in Illinois Tool Works stock by January 2012, all the better. I have earned 4.2% for 5 months exposure and I can repeat the process on ITW stock or another stock.
If I am assigned and Illinois Tool Works Stock price falls as low as $25.60, the 2008-09 bear market low , I know that I can sell the $35 covered call out 5 to 6 months for possibly $.80 in premium. If I can do this twice in a year I will earn $1.60 in call option premium.
Meanwhile I will also earn $1.44 in the dividend if I am in the stock for 1 year. This $1.44 returns 4.1% for the year on my capital of $35,000.00. I also keep the $1.50 from the Jan $35 put I sold and if I can sell the $35 covered call twice I get to keep the $1.60 from that.
The two option premiums give a total cushion of $3.10, which when combined would cut my cost basis in Illinois Tool Works Stock from $35.00 to $31.90. Looking back at Illinois Tool Works Stock prices in the past bear markets, I feel pretty comfortable that I will be exercised at some stage out of my stock at $35.00. Therefore I have a very good chance of not only earning 4.1% on my capital, but another $3.10 in option premiums for 8.8%. Combined the total return on this investment in Illinois Tool Works stock would be 12.9%.
Should the trade not proceed as planned and the stock fail to recover, I still garner the dividend and I have a very good chance of being able to sell covered calls again until I am finally exercised from ITW Stock.
Illinois Tool Works Stock – SUMMARY
While much of the above is based on historic charts, predictions and analysis which will only ever be somewhat accurate, the goal of earning 4% on my capital for 5 months risk in Illinois Tool Works Stock is definitely possible, through a carefully laid out plan that takes into account the downside risk of a stock.
Not only could the trade result in my earning 4% on my capital, but could earn more than double that return in less than a year.
Through studying the historic charts of dividend paying stocks in order to pick bear market lows and then studying option premiums available at option prices I would be willing to accept assignment of shares at, I have found through many years of investing that I can receive returns that are often higher than I anticipated. As well many times this strategy results in capital gains when the stock either does not fall to the low put strike I sell, or if I am assigned, it recovers and exercises my stock from my portfolio and returns me to a cash position to await the next opportunity.
Illinois Tool Works stock is one of many large cap companies which makes possible reasonable income gains with an excellent level of protection when using the above strategy.