In today's market, blue-chip stocks are generally fetching a premium because of the stability they offer. Investment managers have begun paring back exposure to speculative, high-multiple growth stocks, and institutional capital has been flowing into large-cap stocks with more stable long-term earnings.
The chart below offers a good visual of this transition. Notice that the broader market SPDR S&P 500 (NYSE: SPY) is making new highs, while the iShares Russell 2000 (NYSE: IWM) is well off its March highs.
At this point, I am much more comfortable setting up income trades on blue-chip stocks that are increasingly attractive to institutional investors, as these are likely to hold up well and pose less risk for our put-selling strategy.
Shares of General Electric (NYSE: GE) were tarnished during the global financial crisis because of the company's financial arm, which was subsequently dubbed "a hedge fund in drag." Despite the fact that GE had a profitable portfolio of industrial business lines, the embedded risk from its derivative positions nearly took the company under... before Warren Buffett came to the rescue.
Today, with Buffett's help, GE has emerged from the financial crisis, having steadily reduced the effect of GE Capital on its total revenue. In fact, GE is planning to spin off its North American consumer credit business later this year and to buy the energy business of French conglomerate Alstom for $13 billion.
If the Alstom deal goes through, the acquisition would represent GE's largest to date and would symbolize the company's return to its industrial roots. This new game plan also fits perfectly with what institutional money managers are looking for: a focus on reliable cash-generating business lines.
GE pays a dividend yield of 3.3%, but we have an opportunity to generate a substantially higher yield with a put-selling trade. In fact, I see a setup that could generate an annualized return of 22%.
As of this writing, GE June 27 puts are selling for about $0.57 per share, or $57 per contract. By selling these puts, we are agreeing to buy 100 shares of GE at the $27 strike price should the stock be trading below this level when the options expire on June 21.
Therefore, we will need to set aside $2,643 per contract (plus the $57 in premium from selling the puts) in case shares are assigned.
GE is currently trading just below $27. The stock has been steadily rising since February, and I expect shares to move higher over the next month as the flight to safety continues.
If GE is above $27 when the puts expire, we will be able to keep the $57 per contract that we received for selling the puts. This income represents a 2.2% return on the $2,643 in capital that we set aside. Because we can generate this income in just 36 days, our per-year rate of return nets out to be 22%.
Keep in mind that if the stock remains below $27 and we become obligated to buy shares, we will then be able to collect all future dividend payments and have the option of selling covered calls against our position to generate additional income.
Action to Take --> Given the stability of this company, the shift in investor sentiment toward blue-chip names, and the healthy transition GE has put into play, I would be happy to take a long-term position in this stock. At the same time, an annualized return of 22% is also appealing.
This article was originally published at ProfitableTrading.com:
Blue-Chip Survivor Could Yield 21% a Year (If You Play It Right)