Watch stocks you care about
The single, easiest way to keep track of all the stocks that matter...
Your own personalized stock watchlist!
It's a 100% FREE Motley Fool service...
Isn't it just great when things work out? I first wrote about Whirlpool (NYSE: WHR ) , the world's largest washing machine maker, back in April, shares were near $90, and I noted that appliance manufacturing is not the type of business you should pay up for. I concluded that I'd have more interest in the $5.6 billion fridge king if its shares dipped to $75.
Well, they have. But instead of just buying shares, I think I'd be better off setting up a covered strangle on Whirlpool's shares. Sadistically interested?
Giving Whirlpool a whirl
There's more to this iconic brand than you think. Whirlpool owns six different billion-dollar brands, including Maytag, KitchenAid, and Brastemp -- the dominant brand in Brazil. Whirlpool generates almost half of its $18 billion in revenue from outside of the United States, making it a truly global powerhouse. It has the No. 1 brand in Latin America, No. 2 in India, and a growing presence in China. It has been growing international sales by 8%, even in a tough global economy.
The company's size gives it cost advantages in research and development, as well as in purchasing ever-more expensive commodity inputs. Its competitors just don't stack up: Electrolux (OTC BB: ELUXY.PK) focuses on high-end consumers, General Electric's (NYSE: GE ) appliances lack identity, and Kenmore -- owned by Sears Holdings (Nasdaq: SHLD ) -- is only an afterthought for its struggling parent company. Whirlpool, on the other hand, is methodically building out its brand portfolio at different price points and technology levels. And it's improving its distribution by building relationships with feature-savvy resellers, like the growing big-box retailer hhgregg (NYSE: HGG ) and electronics bastion Best Buy (NYSE: BBY ) .
While Whirlpool does carry a massive debt load ($4.6 billion including its pension obligations), it also turns 4%-5% of every sales dollar into free cash flow, so it's got money left over even after paying its sizeable obligations. With $1 billion in the bank, the company has the financial health to carry its international growth and brand expansions through to su ccess. I think shares could be worth closer to $100, though a tough housing market and lousy economy may keep them suppressed for a while.
Set up your strangle
A covered strangle combines three investment positions, achieving its maximum rewards with a mild upward move in the stock. It sounds complicated, but it isn't:
- You own 100-share blocks of a stock.
- You write out-of-the-money call options.
- You write out-of-the-money put options.
And generally, the owned stock portion is sized to represent half of a full allocation, because the written put option would potentially put you on the hook for the other half.
What's it all mean?
Because a covered strangle requires you to buy the stock in question, it's a clear sign that we think shares are undervalued and that we're bullish over the long term. The written call options are an admission that shares will probably be kept down in the near term. And the written puts signify your willingness to buy another slug of shares if they fall to a price you love.
To sum it all up: You bought shares because you want to own them, you'd be willing to buy more if shares fell to your written put strike, and you'd be willing to sell if shares surprised you and traded up to your written call strike. And of course, for each of the options you write, you'll be paid an option premium and have a chance at improving your returns.
See you in September
To execute the covered strangle, we'd have to buy at least 100 shares of Whirlpool stock. Take a look at the following example:
|Option||Premium Earned||Yield on Stock Price|
|Sell 1 September 2011 $72.50 put||$2.85||3.7%|
|Sell 1 September 2011 $82.50 call||$2.45||3.2%|
Source: Yahoo! Finance.
Under this scenario, we're paid $5.50 for agreeing to buy more Whirlpool if it drops to $72.50, and sell if it rises to $82.50, by the September expiration. But if we take into consideration the option income we earn, our effective purchase price for new shares would be $67.20. And our effective sell price on our existing shares would be $87.80. Both of those, 14% lower than the current share price or 14% higher, seem like pretty solid outcomes for three and a half months work. And if Whirlpool shares stay between the $72.50 and $82.50 strike prices, we simply keep the 6.9% option payment as profit.
The main risk of writing covered strangles is that you take on the downside risk of additional shares. If Whirlpool tanks, your owned shares tank, and you've promised to buy additional shares at the put strike price -- a double whammy. So be sure you're comfortable with the company's risks before trying a covered strangle.
Whirlpool stock itself may turn out to be a solid investment, but the added strangle provides additional profit potential. The covered strangle is just one of the options strategies we use to generate income in Motley Fool Options. To learn more, click here.