I've never quite understood some people's vehement opposition to stock splits. Don't get me wrong, I've got plenty of distaste for companies that use splits as way of marketing their stock, as I think Motley Fool Rule Breakers pick Taser International (NASDAQ:TASR) did -- at least back before it split itself down below $10 "the hard way" -- or like that goofyRocky Mountain Chocolate Factory (NASDAQ:RMCF)
Furthermore, I fully understand the usual "pie math" of stock splits. Simply put, dividing a pizza into more slices doesn't give us any more pizza.
But I suspect some of the love for non-split stocks like Berkshire Hathaway or The Washington Post Co. (NYSE:WPO) is admiration for Warren Buffett, who is associated with these kinds of three- to five-digit stubs.
Don't get me wrong. I think Buffett is way cool. But I'm not Warren Buffett, much to my wife's chagrin. Neither, I suspect, are you. (If you are Warren Buffett, I hope the weather in Omaha is treating you well.)
So, if I'm not Warren Buffett, that means a few things. One, I don't have Buffett's wads of cash. A corollary: This means I'm buying small positions, certainly not entire companies. And finally, I like to invest in stock options now and then.
And that, in a nutshell, is why I like stock splits, at least when they keep a stock's price within a range that lets me take advantage of options.
Don't be hatin'
Now, at the Fool, we usually tend to come down pretty hard on options, too, using loaded words like "risky" and "losing all your capital." Yes, options can be "risky," but no more risky than other stock investments. Do I need to get you a chart on Sun Microsystems (NASDAQ:SUNW), or JDS Uniphase -- which the Fool actually recommended at one point, to its never-ending embarrassment -- to show you how bad a common stock can get? How about our old friend Enron? CMGI, which some of my smartest colleagues also owned? OK, enough said. There's plenty of risk out there.
In fact, options strategies can be just as "safe" as any other stock trade -- maybe safer, in some cases. But you need to know what you're doing, and be sure you're getting what you want. (If you need a Foolish newbies' guide to options, review this article, and maybe this one too.)
For my money, the "safe" way to trade options is by writing them. I like having time on my side, and not just because it brings back fond memories of the Stones, Sally Johnson, and junior high dances in the St. Agnes church basement.
Writing covered calls -- call options on stock that I actually own -- has been a good way for me to earn extra income. I'm essentially paying myself a little dividend on stocks that don't otherwise pay anything. One caveat: Short-term options premiums on staid biggies, such as Motley Fool Inside Value pick Home Depot (NYSE:HD), tend not to be worth a small investor's time. But with smaller companies with more volatile prices, such as Motley Fool Hidden Gems pick CryptoLogic (NASDAQ:CRYP), writing covered calls might be profitable, even for a small fish like me.
And writing or "selling" puts is a good way to get paid to wait for a price at which you'd be happy to own a stock anyway; if it doesn't reach that level, you simply pocket the dough. And writing options like these is precisely why I prefer it when stocks I like trade between $15 and $70 a share. Here's why.
Tyranny of the round lot
Option contracts cover 100 shares. That means that writing a contract for a $15 stock puts you on the hook for $1,500 worth of stock. Writing a contract on a $142 stock puts you on the hook for $14,200 worth of that stock.
Write a put option for that stock? You'd better have the full $14,200 ready to deploy should those shares be put to your account. (Or prepare to pay margin interest when the stock arrives.) Write covered calls? You need to be prepared to get rid of the entire $14,200 worth of that $142 stock. As you can see, for small investors, high stock prices can make options-writing strategies much more difficult.
A quick example
Let's say you invested $2,000 in SanDisk (NASDAQ:SNDK) a little more than a year ago (like I did), when it popped down to $20 a share. Since then, it's up what seems like a gagillion percent, to about $68 a share. That position would now be worth $6,800. Let's say this now represents too big a chunk of your whole portfolio for you to sleep well at night, and you think the current high prices are more than fair.
Well, you could just sell half your shares and be done with it. Or, you could wait for $70, or $75, then sell. But wouldn't you rather get paid to hold out for your sell price? Especially if you have a sneaking feeling that investor euphoria might help it get there soon? Sure you would.
Writing covered calls would let you do that, or keep the option premium if the stock doesn't hit your target price. In fact, when SanDisk first clipped up past $65 a few weeks back, you could have sold covered calls at the $75 strike price, expiring this month, for nearly $3 per option. If the stock finishes at $75 on the expiry date this month and is called, the writer of the option will have been compensated with a total of $78 per share ($75 per share plus the $3 option premium). That's a 20% advantage to the $65 price at the time the option was written. If the stock doesn't close in the money, the writer keeps the $3 per option, representing a 4.6% "yield" on the shares, from that $65 over the seven-week period. Not too shabby.
Except that if you hold only a single, 100-share lot of SanDisk, you can't shed part of your position this way. It's all or nothing, which is why our hypothetical investor might think a 2-for-1 split would be just fine. With 200 shares at $34 each, instead of 100 at $68, our investor could sell calls on half the position.
Or, if another investor thought the stock would be a good buy at a 12%-ish discount, that investor could sell puts for the appropriate strike price -- say, $60. But if our investor doesn't want a full $6,000 shares worth of the stock ($60 x 100 shares), she's out of luck. On the other hand, if the stock were split 2-for-1, our trader could sell puts on $3,000 worth of the stock, which would be one contract at a $30 strike.
With a more moderate share price, our investor simply has more options (pun originally unintended, but left upon reflection) at her disposal. I have a hard time seeing that as a bad thing.
Foolish bottom line
Please note; I'm not trying to suggest that SanDisk should split here, but then, I was lucky enough to pick up more than one round lot back when SanDisk was cheap. Nor am I suggesting that options are for everyone. (For the record, I engaged in just the above-described covered call strategy on SanDisk with a portion of my long position, meaning I'm pretty happy no matter where the price heads this month.)
I'm just want to point out that you don't have to be opposed to stock splits to be Foolish. The size of the price tag on a stock -- even divorced from the context of book value, earnings, or cash flow -- is not completely meaningless, at least to those of us who work with options in smaller, diversified portfolios.
For related Foolishness:
- Should you be considering stock options?
- Learn how to get paid to wait.
- Jim Gillies has some thoughts on buying options, and some on selling puts.
- Check out more on Rocky Mountain Chocolate, including Bill Mann's original nugget.
You want options? Several of the companies discussed here are recommendations of Fool newsletters. Not SanDisk, though Seth tried to get his colleagues to see the light. We can't find every great stock, but we've got plenty of market-beating stock ideas for every investor. Better yet, you can get a 30-day trial for free.
Seth Jayson just likes to have options, that's all. At the time of publication, he had shares of Cryptologic, Home Depot, and SanDisk, as well as covered calls on part of the latter position. View his stock holdings and Fool profile here. Fool rules are here.
