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Keeping Your Coke Position Bubbly

This options strategy would allow for quite good returns, and with less risk than a simple buy.
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Many otherwise normal people are hooked on a substance of dubious necessity, yet is consumed and desired on a worldwide basis: Coca-Cola (KO) stock. Among these people is billionaire Warren Buffett -- who is, through Berkshire Hathaway (BRK.A), one of the biggest holders of these shares.

When it comes to Coke, those who had simply bought and held 10 years ago have done well. Almost the entire return from that decade came post-financial crisis, from March 2009 to the present. If you entered the trade at peak valuations, such as in 2004 and 2007, it often would have taken years for the position to get back to even. See the red, double-headed arrows on the chart below for the timing and evidence of these periods.

All data is adjusted for the 2-for-1 stock split from this past August.

Coca-Cola (KO) -- Weekly

Source: BigCharts.com

View Chart »View in New Window »

Today's price-to-earnings ratio of 18.8x, and dividend yield of 2.71%, fall squarely in the middle ground between overvalued and bargain-priced territory. Many are craving some Coke for their portfolios, but are unsure as to which way the stock might head over the next year or so.

These folks might want to consider the following relatively conservative plan, which would allow for quite good returns while limiting risk to less than what one would take on simply by purchasing shares.

I call this technique a buy/write combination play. You would buy 100 shares, or any larger round multiple of 100, while simultaneously selling January 2014 $37.50 calls and January 2014 $37.50 puts. Here is what that would look like on that 100-share basis (ignoring commissions).

Here are the two possible outcomes on the option-expiration date, 13 months from now.

If Coca-Cola shares remain above $37.50 on Jan. 18, 2014:

  • The call will be exercised.
  • You will sell your 100 shares for $3,750.
  • You will likely have collected at least $102 in dividends (4 x $0.255).
  • The $37.50 put will expire worthless (which is good for you, the seller).
  • Your final position will be no shares and $3,852 in cash.

Net profit will be $3,852 - $3,221 = $631.

That best-case scenario would provide $631 / $3,221 = 19.6% in total returncash-on-cash.

If Coca-Cola shares end up below $37.50 on Jan. 18, 2014:

  • The call will expire worthless.
  • You will keep the original 100 shares of Coca-Cola.
  • You will likely have collected at least $102 in dividends (4 x $0.255).
  • The $37.50 put will be exercised.
  • You will be forced to buy another 100 Coca-Cola shares.
  • You'll need to lay out an additional $3,750 in cash.
  • Your final position will be 200 Coca-Cola shares, plus $102 in cash.

Your 200-share position will have a net effective cost of $3,221 + $3,750 - $102 = $6,869. That averages out to $34.345 per share.Coca-Cola stock could fall up to 8.8% without causing a loss on this trade.

The best case, described above, will play outif Coca-Cola shares go up or remain unchanged, or even if it dips slightly to $37.50. The worst-case scenario, being put another 100 shares, is unlikely to be a bad result for patient investors. I haven't assumed an increase in Coke's 2013 dividend rate, either -- and this is almost certain, based on history.

You could face an early exercise of the LEAP call described just before one of next year's ex-dividend dates. If so, you'd miss out on one or more of the payouts. However, you'd unwind one end of your combination far ahead of schedule, and you'd be able to put your cash back to work sooner.

This is a low-risk, moderate-return trade with a high probability of success.

At the time of publication, Price had no positions in the stocks mentioned.