Dabbling in the stock market

I guess I need to start out by saying that the opinions expressed within are my own and by no means are a recommendation to buy stocks or options. You should consult a financial adviser before making any transactions. Thank you SEC.

Now that that’s out of the way, I decided to start creeping back into the stock market. It’s not because I think that now is a better time than any other to buy, I’m just trying to beat the 1% or less I’m getting in my savings account.

Over the years I’ve learned to really respect the stock market and because of this I’ve had sizable gains over each of the past 3 years. I don’t “trade” anymore, but rather buy and hold companies that I have a strong belief in. I also use several options strategies such as covered calls and naked puts to enhance my gains.

Criteria that I use before buying any stock:

1. The company must turn a profit – I got myself into a lot of trouble when I was younger buying companies with negative profits and I tend to stay away from these now. I want large, stable companies that have a long track record of making money.

2. Low P/E ratio – I generally look for companies that have a low P/E ratio. In reality this is really the price, not the share price. I generally like to find companies that have a P/E ratio of 20 or less, but I will make exceptions to go as high as 30.

3. History of dividends – A company that pays a dividend generally is most stable than a company that doesn’t. It also allows you to get income on your investment while you are holding it. On top of that the tax rate on dividends is 15% vs the standard income rate of short term capital gains.

Strategy:

I think it’s important to note that my strategy is to buy a little bit at a time. This way I can use dollar cost averaging and not subject myself to short term variance. I normally start by buying 25% of my position at first and add to it over several months. I don’t get emotional about stocks or chase them. I set a price (limit order) to buy my stocks and don’t adjust the price after that. Sometimes it takes weeks or months for my orders to fill. Sometimes they don’t fill at all – that’s ok.

Goals:

I don’t set any goals to get rich quick. I know it’s possible to hit home runs, but my strategy is to simply earn at least 7% per year. I really like to shoot for 10%, but the reality is that 7% is about the best I can ever expect. I keep my commissions low by making as few trades as possible (I use eTrade). I never use a high priced broker or managed money funds that take a fee. No one can beat the market long term and I’m not giving even 1% to someone else to manage my money.

Methodology:

My strategy right now is to find companies with a dividend yield of more than 5%, buy these companies, and then immediately sell a long-term covered call (LEAP) on them. I’m looking for a ratio that earns me more than 8% total between the covered call and dividend payments provided that the share price remains the same for a year.

Recent Transactions:

With all this said, I just made two transactions this month that I hope will work out well for me in the long run.

Transaction One – Altria Group Inc

My first transaction was to buy Altria Group Inc (MO). For those of you who don’t know what Altria is, they are a global tobacco manufacturer. They are the old Phillip Morris, until they spun that off a few years ago. Basically, Altria is the international Phillip Morris. I personally hate tobacco and I’m very against it, but at the same time I’m not beyond making money off their stock. The reality is that many people still smoke and are going to continue to smoke. Altria’s P/E ratio is 12.7 and their dividend yield is 6.4%. Here is what I did:

I purchased Altria at $23.79 and then sold the Jan 2012 $25 covered calls on it at $0.75. This brought my cost basis on Altria down to $23.04 (The cost of the stock minus the profit from the covered call). On top of this Altria pays a dividend of $0.38 per quarter, or $1.52 per year. So, I have 3 scenarios that can happen here.

1) The stock closes above $25 per share in Jan 2012. In this case my shares will be sold for $25 no matter how high the stock is. This means I would have made a total profit of 14.6%.

2) The stock closes below $25, but above my cost of $23.79. This means I will have made a profit of 9.5% PLUS any additional amount over my cost basis of $23.79.

3) The stock closes below my initial cost of $23.79. Since I got $0.75 for the covered call and I’ll earn $1.52 in dividend payments, my true cost is $21.52 for the stock (a 9.5% discount to where the stock is today). So, if the stock is at or above $21.52 I will still make a profit. At this point I will still own the stock and can sell more covered calls if I wish and collect more dividend payments. As long as the dividend remains the same I will still be collecting 6.4% just by holding the stock.

Transaction Two – AT&T

My second purchase was AT&T (T). I really wanted to buy Verizon, but their P/E ratio was at an unacceptable 39.5 compared to AT&T at 8.55. AT&T’s divided was also higher, that clocks it at 6.26%.

I purchased AT&T at $28.33 and then sold the Jan 2012 $30 covered call on it at $0.99. This brought my cost basis on AT&T down to $27.34. AT&T pays a dividend of $0.43 per quarter, or $1.72 per year. Here are my 3 scenarios for AT&T.

1) The stock closes above $30 per share in Jan 2012. In this case my shares will be sold for $30 no matter how high the stock is. This means I would have made a total profit of 15.4%.

2) The stock closes below $30, but above my cost of $28.33. This means I will have made a profit of 9.5% PLUS any additional amount over my cost basis of $28.33.

3) The stock closes below my initial cost of $28.33. Since I got $0.99 for the covered call and I’ll earn $1.72 in dividend payments, my true cost is $25.62 for the stock (a 9.5% discount to where the stock is today). So, if the stock is at or above $25.62 I will still make a profit. At this point I will still own the stock and can sell more covered calls if I wish and collect more dividend payments. As long as the dividend remains the same I will still be collecting 6.25% just by holding the stock.

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2 Comments

  1. I take issue with “No one can beat the market long term.” You should read The Big Short by Michael Lewis. It will blow your mind.

    I do agree, to near absolute certainty, that you won’t find anyone working for a big bank or brokerage firm that will get you there. But there are plenty of ways to beat the market for people who are actually smart and do their own research – which unfortunately again aren’t commodities offered by the Charles Schwabs of the world.

    Reply
    • I actually had that book on my Amazon wish list for quite a while and just purchased it for my Kindle.

      I should qualify my statements in that I don’t think an individual investor can beat the market long-term by trading. Individual investors are behind the 8 ball the second they make a trade. When you factor in the spread and commissions it normally accounts to .5% – 3% of the transaction. Plus, the information individual investors have is not going to make them money long-term. There are too many outside factors that hurt the little guy. If you are trading (meaning that you are buying and selling the stocks you buy every day, week, or month) then you are fooling yourself if you think you can make money.

      There is the old adage that stocktips are like assholes, everybody has one. Personally, I’ve found something that’s worked well for me over many years and market cycles. I think everyone needs to find their comfort zone.

      Thanks for the book recommendation. I’ll try to read it in the next month or two.

      Reply

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