From time to time, Mr. Market gives us a chance to make an exceptionally high return on our invested capital by using an options strategy. In the case at hand, we can sell put options on giant chipmaker Intel and earn 5.5% by having to wait only 3 months. Repeat this trade four times a year, and you’re looking at a whopping 22% annualized — on a relatively boring stock.
The opportunity
On July 17, Intel Corporation (NASDAQ:INTC) reported second-quarter 2013 earnings and provided guidance for the balance of 2013. The $12.8 billion in revenue was well within the guidance range, and the $0.39 earnings per share was spot on street expectations. But a cloud of disappointment loomed, as full year guidance sank from a “low-single-digit” increase to flat. Shares have tumbled by almost 6% since then.
And that’s exactly what the market is overlooking by focusing on Intel Corporation (NASDAQ:INTC)’s short- term “flat” earnings growth.
How to take advantage of this opportunity
Investors can do one of two things: buy the stock in the open market, or sell put options and pocket fat cash premiums on this trade. As of this writing, shares of Intel Corporation (NASDAQ:INTC) are trading at $22.75, and the October 2013 $23 strike puts are selling for $124. This translates into an immediate 5.45% gain on your investment by waiting only three months until the October 2013 expiration.
To put it differently, investors can act as an insurance company and collect a premium of $124 for each option contract they sell. This contract, in turn, obligates them to buy shares of Intel Corporation (NASDAQ:INTC) on the expiration day of October 2013 if shares are trading under $23. Repeat this trade four times a year, and, if conditions hold, you will make 22% annually, pre-tax.
How this plays out
There are three different scenarios that can happen on expiration day on October 2013:
- Share price of Intel > $23: You get to pocket the premium and have no obligations.
- Share price of Intel = $23: You get to pocket the premium and have no obligations.
- Share price of Intel < $23: You get to pocket the premium, but you will also be obligated to buy the shares at the predetermined price of $23. Since this is an excellent price to pay for the shares, you should be fine with that obligation.
It’s a win- win
Our “worst” case scenario in this strategy is to end up owning shares of Intel Corporation (NASDAQ:INTC) (minus the up-front premium we received) at the end of October. You must understand that this is far from a bad scenario. At this price level — Intel shares are a steal, especially when looking forward a few more years down the road. That’s due to the following catalysts:
- Intel invests in the future: Intel’s research and development (R&D) spending rose from $5.7 billion in 2008 to $10.2 billion last year. That, too, will rise this year. By investing heavily in plants and research, Intel consistently makes sure that it’s ahead of the game. That’s how it widens its economic moat. With all this money, it’s building highly efficient plants that will manufacture the 28nm and the 20nm microprocessors of the future.
- Intel – Haswell: Benchmark results on the first Haswell desktop processor – the Core i7-4770K – show significant performance improvements over the last generation chips, especially when it comes to graphics. Graphics performance is set to improve further still with the forthcoming i7-4770R model. This will have a special appeal to gamers, and is likely to give Intel Corporation (NASDAQ:INTC) a great boost forward.
- Intel is very cheap on an absolute level. It currently trades at a forward price-to-earnings of only 11.5x. That’s way cheaper than the average P/E of 18x for the S&P 500. Another way to look at it is through its cash flow. At a current market cap of $110 billion, Intel is trading for less than 6 times annual operating cash flow. And for that price, you receive a company with a 24% operating margin.
Two important caveats
The strategy mentioned above is regarded in the industry as “naked put selling.” The goal here is to boost our overall return by committing to buy Intel Corporation (NASDAQ:INTC) shares, at a predetermined price. It makes perfect sense, but you need to keep two things in mind.
First, you need to adjust the number of Intel Corporation (NASDAQ:INTC) shares you are obligated to purchase to the trading position size that is right for you. Never commit to buy more shares than you are financially able to.
Second, with these types of transactions – your broker will ask that you put aside a certain percentage of the total value of your commitment in cash or marketable securities. The purpose of this margin is to back up your commitment to buy Intel shares. You can check out FINRA’s specific margin requirements here.
The Foolish takeaway
I recommend that you sell to open the Intel Corporation (NASDAQ:INTC) October 2013 puts, at the $23 strike price, for no less than $120 per option contract. This translates into an immediate 5.45% gain on your investment by waiting only three months until the October 2013 expiration. Selling put options on Intel is the safest way to generate income from a blue- chip stock while you wait. Invest accordingly.
Shmulik Karpf has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway and Intel. The Motley Fool owns shares of Berkshire Hathaway and Intel.
The article How You Could Make 22% a Year With This Chipmaker originally appeared on Fool.com.
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